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Going Private: The Unstoppable Rise of China’s Private-Sector Entrepreneurs

Qing Jun-style, from China First Capital blog post

China’s private sector economy continues to perform miracles. According to figures just released by China’s National Bureau of Statistics, private companies in China now employ 70 million people, or 80 percent of China’s total industrial workforce. These same private companies account for 70% of all profits earned by Chinese industry. Profits at private companies rose 31.4% in 2008 over a year earlier, while those of China’s state-owned enterprises (so-called SOEs) fell by 16%. 

The rise of China’s private sector is, in my view, the most remarkable aspect of China’s economic development. When I first came to China in 1981, there were no private companies at all. SOEs continued to be favored sons, until recently. Only in 2005 did the Chinese government introduce a policy that gave private companies the same market access, same treatment in project approval, taxation, land use and foreign trade as SOEs. During that time, over 150,000 new private companies have gotten started and by 2008 had annual sales of over Rmb 5 million.   

These statistics only look at industrial companies, where SOEs long predominated. By last year, fully 95% of all industrial businesses in China were privately-owned. In the service sector, the dominance of private companies is even more comprehensive, as far as I can tell. While banks and insurance companies are all still largely state-owned, most of the rest of the service economy is in private hands – shops of all kinds, restaurants, barbers, hotels, dry cleaners, real estate agents, ad agencies, you name it. 

Other than the times I fly around China (airlines are still mainly state-owned) and when I pay my electric bill, I can’t think of any time my money goes directly to an SOE. This is not something, of course, I could have envisioned back in 1981. The transformation has both been so fast and so thoroughgoing. And yet, it still has a long way to go, as these latest figures suggest. Almost certainly, private company business formation and profit-generation will continue to grow strongly in 2009 and beyond. SOE contribution to the Chinese economy, while still significant,  grows proportionately less by the day. 

There once were vast regional disparities in the role of the private sector. Certain areas of China, for example the Northeast and West of the country, were until recently still dominated by SOEs. But, the changeover is occurring in these areas as well, and every year more private companies will reach the size threshold (revenues of over Rmb 5mn) where they will be captured by the statisticians. 

Equally, every year more of these private companies will reach the sort of scale where they become attractive to private equity investors. That happens when sales get above Rmb 100mn.  

Never in human history has so much private wealth been created so fast, by so many, as it has in China over the last 20 years. And yet, all this growth happened despite an almost complete lack of outside investment capital, from private equity and other institutional sources. This shows the resourcefulness of China’s entrepreneurs, to be able to build thriving businesses with little or no outside capital. Imagine how much faster this transformation would have happened if investment capital, and the expertise of PE firms, was more widely available. It is becoming more available by the day. 

China is primed, as it’s never been, for spectacular growth in PE investment over the coming 20 years.

China’s government — an example for the world on competent economic management

Yuan Dynasty blue-and-white porcelain vase

China’s government is managing very ably the global financial crisis, and continuing to deliver to its people a better standard of living. Yes, the economy in China is growing more slowly than it has over much of recent history, at around 7%-8%. But, overall, the country continues to bustle as nowhere else does. People still have spring in their step, and the same sense of boundless potential.

This is a measure of just how many things the Chinese government has done right economically. It’s a fact that’s too rarely remarked upon outside China, where the major talking points about China’s economy tend to be pollution, corruption and what’s seen to be the artificially-low level of the renminbi. This does a huge disservice to what’s been highly successful and competent management by China’s economic policy-makers. 

How good a job has the Chinese government done? Consider this: the country has managed, with relatively limited economic dislocation, the huge contractions in China’s export markets over the last year. Yes, factories have closed and workers have lost their jobs. This is a familiar enough boom-and-bust story in every country where manufacturing plays a big part in the overall economy. But, not long ago, most of China’s economic well-being was tied to its manufacturing exports. There was little other fuel for economic growth. 

China today is a very different place, economically, than it was even three years ago. The domestic market, not exports, is now the locomotive that’s pulling 1.4 billion people down the track. This shift was managed so deftly by the Chinese government that it’s hardly even been noticed outside China – and often inside as well. I run into a lot of Chinese who still believe that the fate of the nation is determined by the output of its assembly lines. Exports and manufacturing are still important, hugely so. But, they matter less than they did just a while back, and in the future, they will matter less. 

This shift away from manufacturing has caused huge ructions in other countries – just think of the endless labor strife in France, or Britain on the 1970s, and the persistent high unemployment in most other European countries. They have stumbled along, economically, as their competitive advantage in manufacturing was lost. 

In China, it’s a very different – and better – picture. There is so much economic opportunity here that people can, with far less disruption to their lives than in Europe, find new places to work and build a future. The Chinese government creates the circumstances that allow all this economic opportunity to occur. Again, the contrast with Europe is particularly marked. In Europe, economic activity is stifled by excessive regulations that set out who can do what, where, for how much. In China, the government, wisely, takes a much lighter approach to regulation, always with an eye focused on creating circumstance that will lead to new jobs, more activity, and more competition in most sectors of the economy. 

China’s government, rightly, does get credit internationally for the economic changes over the last 30 years that have lifted some 500 million people out of poverty. This is, unquestionably, the most important economic achievement of the last century, if not the last millennium. 

But, the policies that are generating China’s continued prosperity — the uplift that is carries as many Chinese into the middle class as were taken out of poverty — is much less well-followed and less-praised. That’s wrong. Arguably, it’s no less significant an achievement.

 

 

American and Chinese entrepreneurs: they are very different, but the best are equally good at making their investors rich

han-dynasty-coin

Held each year in Los Angeles, the technology conference organized by the investment bank Montgomery & Co. is one of the best of its kind, anywhere. It brings together about 1,000 people from the top American venture capital and private equity firms along with senior management at some of the most accomplished privately-owned technology companies in the US. It provides a very focused snapshot of some of the strongest new tech business models and where venture capital and private equity firms are looking to invest this year.  

I was at the conference from start to finish, in meetings and panels. It was a great gathering in every respect, with a level of optimism that runs counter to much of the economic gloom that dominates the headlines. One reason: good technology can thrive in bad times. Corporate budgets are getting squeezed and each purchase is more tightly scrutinized. This means that many new tech solutions, offering good or better performance at lower price, have a great opportunity to gain market share against more lumbering competitors. 

I saw some interesting companies with interesting business models, in particular several that were focused on SaaS (“Software-as-a-Service”) solutions that can dramatically lower for businesses large and small the cost (both hardware and software) of implementing enterprise software. SaaS makes so much sense because companies can switch to a powerful software solution, but without the need to buy and install any of the software or hardware to run it. It’s all done using an internet browser as the main interface. The software is hosted and managed on a central server by the company that developed it. Users pay a monthly or annual fee to use the software. 

SaaS is an area where I have a special interest. I’m lucky enough to be CEO of Awareness Technologies (www.awarenesstechnologies.com), which develops and sells SaaS-based corporate security software. Awareness also has as its founders two of the best entrepreneurs I’ve ever met, Ron and Mike. They are superstars.

Great entrepreneurs are rare, even in a conference of hot technology companies. Of the 100 tech companies at the Montgomery conference, very few – by my very unscientific study — seemed to have a great entrepreneur at the controls. Most are venture-backed, and so tend to have very experienced professional managers at the top. Often, the founding entrepreneurs have been pushed out, or given different roles, after the venture capital money arrives. One obvious reason for this: the venture capital and private equity partners are usually from similar backgrounds as the professional managerial class, with gold-plated resumes and MBA degrees from the best universities in the US.  Institutional investors often look for a safe pair of hands, and not a visionary, to run a company once their money is committed. This is sometimes the right choice.

That’s the usual pattern in the US. I was struck, not surprisingly, by the differences in China. Great entrepreneurs are no less rare, but it’s almost impossible for me to imagine a situation where the founder of a Chinese company is pushed aside by the venture capital or private equity firm after its put its money in. That would, in most cases, be sheer madness. First, there is no large “professional managerial class” in China at this point, with experienced managers who have run successful businesses previously, and then either sold them or led them to IPO.

Second, and perhaps even more important, good Chinese companies, in my experience and to an extent rarely seen in the US, are one-man shows. There is usually as boss and owner one superbly talented, charismatic, driven and shrewd individual, who saw a market opportunity and seized it. Against unimaginable odds – including the severe ack of capital, continually changing regulations, predatory officials, the primitive market economy of ten years ago in China, and the fiercest competitors – these successful Chinese business owners managed to build large and thriving companies. Single-handedly. There is usually no “management team” to speak of — just one man of outsized abilities and an equally outsized will to succeed.

Another difference with the US: the best entrepreneurs in China, and so the best investment opportunities for venture capital and private equity firms,  aren’t likely in the technology business. They most often are in what are considered, in the US, old-line, low-growth businesses like manufacturing, retailing, branded consumer goods. In the US, companies in these sectors find it nearly impossible to raise money from venture capital and private equity companies. In China, it’s where most of the VC and PE investment goes.

It’s what makes China such an interesting place to be for venture capital and private equity, and why I feel so lucky to have a business there in that field. China has both the most sophisticated global investors and the most well-run, entrepreneurial smokestack industries.

Of the 100 companies at the Montgomery conference, I can’t think of a single one that runs a factory and manufactures a tangible product. The guys who run these companies are almost certainly all college graduates, often with advanced degrees, looking for money to complete or market a website, a software application, an internet advertising platform. In China, conversely, a conference filled with some of the better, more promising private companies would have 100 men, most with only a high-school education, looking for money to expand their factories, fulfill more customer orders and so double their revenues and profits in the next year or  two.

As someone who has spent a big part of his life managing technology and venture capital businesses, I see great opportunities to make money investing in both China and the US. The big difference is that in the US, the biggest risks for venture capital and early stage private equity investors tend to be technological, that the company you’ve invested in may not succeed because its product or service doesn’t work as planned, or isn’t as good as a competitor’s. In China, technology risk is usually minimal. The big risk for venture and private equity firms is that the rules may change, and the company you’ve invested will not be able to freely operate in the domestic market in China.

How do I manage risk personally? I try to eliminate it, by working with the best entrepreneurs. I’m confident Awareness Technologies will widen its technological lead, become the dominant SaaS-based security software company and make its investors a ton of money. Equally, I’m confident the Chinese companies we work with at China First Capital will become dominant in their industries in China and make their investors a ton of money. Along the way, the men running these Chinese businesses will continue to do what they’ve always done: find ingenious ways to stay one step ahead of competitors and any changes in the country as a whole.

AltAssets writes on China First Capital’s Report on Private Equity in China 2009

AltAssets is among the world’s leading sources for news and analysis on the global private equity industry. They just published a summary of my firms report, 2009 Private Equity and Strategic M&A Transactions in China — A Preview“. 

AltAssets is based in London, and provides news and research to more than 1,000 institutional investors and 2,000 private equity and venture capital firms worldwide.

Here is what they wrote about the China First Capital report:

 

altassets_logo

CHINA THE MOST ROBUST EMERGING MARKET FOR PRIVATE EQUITY AND VENTURE CAPITAL SAYS REPORT”


China continues to be the world’s most robust emerging market for private equity and venture capital finance, even in a difficult global economic environment, according to the Private Equity and Strategic M&A Transactions in China 2009 report just released by China First Capital, a boutique investment bank with offices in China, Hong Kong and the USA.

Peter Fuhrman, China First Capital’s chairman and the report’s author, said, “While the overall investment environment remains challenging and the effects of 2008’s turbulence are still being felt, 2009 will be a year of unique opportunity for private equity, venture capital and M&As in China.” 

China’s economy continues to grow, powered largely by successful small and medium private businesses, many of which are among the fastest-growing companies in the world. Private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1bn in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market. 

“In 2009, China should rightly be among the most attractive and active private equity investment markets in the world,” the China First Capital report predicts. “Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.” 

The report identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are: the drive for industrial consolidation; profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA; increased importance of convertible debt and other hybrid financings; opportunities for strategic M&As; well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market. 

“The pathways to success in China are fewer and narrower than in recent years. But, for the entrepreneurs and private equity investors that can navigate their way in 2009, this will be a year of abundant opportunity,” Fuhrman added. 

Copyright © 2009 AltAssets

Private Equity and Strategic M&A Transactions in China 2009: A New Dawn

China First Capital, a boutique investment bank, releases comprehensive analysis of five key trends for 2009 in Private Equity, Venture Capital and M&A markets in China.jpg

My firm, China First Capital, just completed our annual report on Private Equity, Venture Capital and Strategic Mergers and Acquisitions in China. I had the biggest hand in writing it, so the opinions expressed are my own. My view, overall, is one of realistic optimism. China will continue to be the world’s most robust emerging market for private equity and venture capital finance, even in a very difficult global economic environment. A big reason for this is the continuing strong performance of many private SME companies in China, especially those focused on the domestic market, rather than exports. 

China First Capital has a special affinity for these strong private SMEs. They are the only companies we choose to work with. There a few reasons for this. A big one is my personal conviction that the most important predictor of a success in private equity investing is putting money into a company with a truly outstanding boss. Ideally, the boss will also be the entrepreneur who founded the company. 

You can do all the spreadsheet modeling and projections you want, but nothing else matters quite as much as the quality and drive of the leadership at the top. In many of the good Chinese SMEs, the boss is a first-class business strategist and opportunity-seeker. Give him a dollar and he’ll bring you back five. In many of China’s larger state-owned, or partially state-owned companies in China, the boss is often more a political animal, appointed to the job as much for skills as a bureaucratic infighter as for talents at managing a business. Give him a dollar and he’ll come back in a while and ask you to lend him another three. 

SMEs, no surprise, usually run circles around their state-owned competitors in China. That’s a big reason we choose to work exclusively for SMEs. Another reason: we prefer long-term partnerships with our clients rather than one-off deal-making of larger investment banks. We act as a financial and strategic advisor to Chinese SMEs in a long-term process that often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Thanks to these Chinese SMEs,  China should be among the most attractive – and active – private equity investment markets in the world in 2009. Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Indeed, private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1 billion in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market.

Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.

The report, titled “Private Equity and Strategic M&A Transactions in China 2009”, identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are:

  1. the drive for industrial consolidation;
  2. profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA;
  3. increased importance of Convertible Debt and other hybrid financings;
  4. opportunities for strategic mergers and acquisitions;
  5. well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market.

Here’s the report’s first section. I’ll add more of it in later posts.

 

 Overview  chinese-balance

       

Turbulence creates opportunity

2008 was a year of extremes in China. Extremes of joy and pride, during the Beijing Olympics. Extremes of sadness and shock following the Sichuan earthquake. Even the climate reached extremes, during China’s crippling winter storms early in 2008. 

Financially, 2008 was also a year of extremes. The stock markets in Hong Kong, Shanghai and Shenzhen rose strongly in the first months of the year, and IPOs were plentiful. By mid-year, the markets began plunging, and IPOs dried up. By year-end, Shenzhen, Shanghai and Hong Kong were all down 60% for the year. 

China’s private equity and venture capital investments followed a similar turbulent course, beginning strongly, with over $10 billion invested in Chinese companies in the first half of the years, and then the pace of new investments slowed to a crawl.   

Governments in China, the USA and around the world intervened in an unprecedented fashion to stabilize the economy and the credit markets. As we enter 2009, there is no longer any doubt that the world economy is in recession. 

The question now is when will the recovery begin and when will be a good time to begin investing again? I want to offer a personal perspective to our valued relationships, both clients and the private equity firms we work with. As Chairman of China First Capital,  Ltd, with over 20 years of experience in the capital markets, private equity and business analytics, I’ve survived my share of business cycles. One example, I was CEO of a California venture capital company during the Dot-Bust years, the last time private equity investing came to a similar standstill. Within two years, deal activity and valuations resumed their upward momentum. 

My view: the overall investment environment in China remains challenging and the effects of 2008’s turbulence are still being felt. But, 2009 will be a year of unique opportunity for private equity, venture capital and mergers and acquisitions in China. Tough times can be the best time to make money. 

Consolidation and “flight to quality”

 

 

The Chinese economy is under significant strain as 2009 begins, with growth decelerating, factories closing by the thousands and unemployment rising. Many areas of China’s domestic economy are “over-saturated”, with too many companies competing with small market shares. China is ripe for consolidation. 

In the freely competitive markets, the weakest companies will perish. The stronger competitors will be able to add market share and enjoy the virtuous cycle of increasing volumes lowering unit costs, thus boosting profits that can be re-invested to lower still further costs of production.

Chinese consumers will respond as well, and reward with more of their money the better managed companies with the most efficient manufacturing and distribution. Out of this, stronger dominant brands will emerge, and this too will push for greater consolidation.

This process is just beginning in China. China’s domestic market is huge, second only to the US. In many vertical markets (including financial services, consumer goods, distribution and logistics, retailing, fashion), each point of additional market share in China can equate to tens of millions of dollars in additional revenue.

Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate Strong regional companies will acquire competitors elsewhere in China to become national powerhouses.   

For investors, the opportunities will be unparalleled to back the Chinese companies that will thrive during this process of consolidation.  The winners will be able to increase revenues and profits strongly and sustainably, even in a weak economy.

 

 

 

 

 

 

 

 

 

 

 

Stairway to Hell? IPO Activity in China Falls Off a Cliff

 

Not quite “a staircase to hell”, but the graphic below shows the steep fall in IPO activity in China in 2008. It looks pretty scary, doesn’t it? Chinese IPO activity in 2008 was at its lowest level since 2004. IPO activity basically came to a halt towards the end of last year. 

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No one looking at the table will see much room for optimism. But, it’s worth remembering that though down by almost 80% from the year earlier, IPOs of Chinese companies in 2008 still did manage to raise $20 billion of new capital. The key thing now is that this money is used well and wisely, to build profits and market share at these now-publicly-traded Chinese companies. By doing so, these companies will provide an impetus for companies and investors to get back into the IPO market. 

In other words, the IPO market in China is most attractive vibrant not when a company sees a big price jump in its first days of trading. This does little for company, and benefits mainly those who claimed an allocation of shares ahead of the IPO. The key driver for the IPO market should be that the capital raised in an IPO is used wisely, to put companies on a higher growth path. 

Higher profits will boost company valuation, and also allow newly-listed companies to more easily raise additional equity capital in the future. As I sometimes remind the Chinese laoban we work with, “an IPO should not be just a goal in itself, but also the cheapest way to raise additional capital to build your business even faster.” 

Take the money from a public listing to make more money: that’s the quickest way in which Chinese companies can do their part for reviving the IPO market and start building again the “staircase to heaven”, with annual gains every year in the amount of money raised through IPOs. 

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IPO Exit Window — as it slams shut for US companies, it opens ever wider for Chinese ones

That sound you just heard was the IPO window slamming shut for venture and PE-backed companies in the US. In the second quarter of this year, not a single US company went public. This is the first time this has happened since 1978, when the US VC and PE industry was 1% its current size. In other words, these are unusually tough times for the US venture and PE community.

 

Will China soon follow suit? Not likely, in my view. In private equity, as in so many other industries, China and the US are becoming more and more decoupled. Chinese companies will continue to go public, on the US market, as well domestically and in other Asian markets, including Hong Kong and Singapore.  I remain very optimistic about the prospects of Chinese companies now getting PE and venture finance – and no less optimistic about how well many of these investments will do for the PE firms that are investing. For Chinese companies, IPOs and other exits, including trade acquisition,  will continue, at exit values that will reward those investing at typical pre-IPO multiples in China of 6-9x last year’s earnings.

 

Why the different path for Chinese and US companies backed by PE and VC firms? Start with the economy. The US is going through a period of very slow growth, close to, but not yet in, a recession. This, plus the effect of high oil prices, have weighed heavily on the US stock market, which in turn, limits the appetite among investors for IPOs by US companies. IPOs are traditionally far more difficult to arrange during a time of falling stock prices.

 

China’s stock market – as well as those of Singapore and Hong Kong – have followed the US down. That correlation between stock markets still exists. But, even during a down market, Chinese companies can still succeed with a public offering. In Hong Kong, whose overall market has fallen by 18% so far this year, Chinese companies are still going public at a rate of about one a day.

 

What explains this? A big part of it, in my view, is that too much venture and equity capital in the US has gone into technology and biotech, and less to established and profitable businesses. Don’t get me wrong. The technology market in the US is great, and I’m still active in the US venture community. But,  this heavy concentration on two sectors, technology and biotech, is itself a cause of the IPO drought of 2008. Those two industries tend to be both hyper-competitive and volatile. For every Google that goes public, there are dozens of tech companies that take VC funding and then disappear without a trace. A huge percentage of the venture funding goes to early-stage businesses, with zero or limited revenues, and perhaps only some untested IP.

 

So, while American VCs bet heavily on two high-risk/high-reward industries, the overall stock market is made up of many different sectors, with different rates of growth, maturity and different capabilities to respond to competition. In fact, the vast majority of companies listed on the US exchanges aren’t in the technology or biotech industries.

 

Let’s look now at Chinese companies getting PE and VC funding and going public. They are drawn from a far wider range of industries than their US counterparts. The Chinese PE market doesn’t focus on technology companies, or biotechs, or indeed on any single industry. This is a great strength. Chinese companies getting equity finance and then an IPO exit reflect, far more broadly, the overall composition of the stock market, and so the overall investor demand.

 

The other key differentiator  – the Chinese economy continues to grow strongly. It’s increasingly powered by domestic consumption, and will be for decades to come. This, in itself, creates enormous opportunities for the creation of very valuable businesses serving the Chinese domestic market – example:  consumer goods and the businesses that supply those producers.  We are working with a client that manufactures a key component used in disposable diapers, a market that will likely grow by upwards of 50% a year. Fewer than 15% of China’s babies are being swaddled in disposable nappies, compared to over 90% in most middle income countries.

 

My conclusion – as long as private equity capital in China continues to flow into great companies in a wide variety of industries, particularly ones that service the domestic economy, the Exit Window will remain not only open, but ever-larger.