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WikiLeaks Dump Adds to China’s Foreign-Tech Wariness — Wall Street Journal

Leave a Comment / August 11, 2020

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While the purported CIA documents leaked this week by WikiLeaks focus on the likes of Apple and Samsung, Chinese companies like Huawei do get some coverage. 

While the purported CIA documents leaked this week by WikiLeaks focus on the likes of Apple and Samsung, Chinese companies like Huawei do get some coverage.  
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By Eva Dou

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BEIJING—The latest WikiLeaks trove hands fresh ammunition to China’s cyberspace hawks, already pushing to reduce dependence on foreign products that could be vulnerable to espionage, observers say.

“The level of alarm in China will certainly increase, and with it a renewed determination to clamp down still further on U.S. technology companies’ operations in China,” said Peter Fuhrman, chairman of Shenzhen-based advisory firm China First Capital, which follows China’s tech sector.

The documents released this week—more than 8,000 pages in all—purport to show how the U.S. Central Intelligence Agency breaks into computers, smartphones, TVs and other electronics for surveillance. Many documents deal with leading non-Chinese brands like Apple Inc. and Samsung Electronics Co., though there is some coverage of Chinese products, including routers from Huawei Technologies Inc. and Baidu Inc.’s search engine.

The Chinese-product references are relatively sparse—and, in some cases, obscure. An undated list of CIA internal hacking demonstrations, for example, includes the “Panda Poke-Huawei credless exploit”—which one cybersecurity specialist says may be a method for taking advantage of vulnerabilities without logins or other “credentials.” There is also the “Huawei VOIP Collection,” a reference to “voice over internet Protocol,” making phone calls over the internet.

The document doesn’t say whether these methods were used for intelligence gathering. Huawei declined to comment.

A file titled “Small Routers Research-work in progress” lists router models from Huawei and ZTE Corp. It also mentions China’s three state-owned telecom companies and Baidu’s search engine, without further details.

The telecom companies and Baidu declined to comment.

The leak also offered what seem to be workaday notes among colleagues, including one CIA worker’s complaint about one piece of software’s default-language setting. “I don’t speak Chinese,” he griped.

WikiLeaks’ website is blocked in China, but Chinese state-run media reported the document leak, focusing on U.S. companies. Overall response has been muted, possibly because the official spotlight this week is on Beijing’s annual legislative gathering.

Cybersecurity experts say China maintains its own robust cyberhacking apparatus, though Beijing characterizes itself as purely a hacking victim, not a perpetrator.

“China is opposed to any form of cyberattack,” foreign ministry spokesman Geng Shuang said Thursday. “We urge the U.S. side to stop its wiretapping, surveillance, espionage and cyberattacks on China and other countries. China will firmly safeguard its own cybersecurity.”

In recent years, China has seized on leaks about U.S. surveillance to fan public support for its domestic tech products. U.S. tech brands felt a chill after former U.S. National Security Agency contractor Edward Snowden revealed NSA surveillance methods in 2013.

“It is like snow on more snow,” one China executive of a U.S. technology company said of the potential sales impact of the latest leaks.

These leaks could help countries counter CIA tapping and develop their own capabilities, said Nigel Inkster, former deputy chief of U.K. spy agency MI6.

“China, Russia et al will now both be better attuned to the risks posed by these capabilities,” he said, “and will no doubt seek to use them themselves.”

https://www.wsj.com/articles/wikileaks-dump-adds-to-chinas-foreign-tech-wariness-1489061414

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Why Taiwan Is Far Ahead of Mainland China in High-Tech — Financial Times commentary

Leave a Comment / August 12, 2020

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Largan–

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Every country is touchy about some topics, especially when raised by foreigner. Living in China for almost seven years now, and having been a student of the place for the last forty, I thought I knew the hot buttons not to press. Apparently not.

The topic at hand: high-tech innovation in the PRC and why it seems to lag so far behind that of neighboring Taiwan. A recent issue of one of China’s leading business publications, Caijing Magazine, published a Chinese-language article I wrote together with China First Capital’s COO, Dr. Yansong Wang, about Taiwan’s high-flying optical lens company Largan Precision.

Soon after the magazine was published, it began circulating rather widely. Howls of national outrage began to reach me almost immediately. Mainly we were accused of not understanding the topic and having ignored China’s many tech companies that are at least the equal, if not superior, to Largan.

I didn’t think the article would be all that contentious, at least not the facts. Largan last year had revenues in excess of $1 billion and net profit margins above 40%, more than double those of its main customer, Apple, no slouch at making money. China has many companies which supply components to Apple, either directly or as a subcontractor. None of these PRC companies can approach the scale and profitability of Largan. In fact, there are few whose net margins are higher than 10%, or one-quarter Largan’s. Case in point: Huawei, widely praised within China as the country’s most successful technology company, has net margins of 9.5%.

Taiwan inaugurated its new president last month, Tsai Ing-wen, who represents the pro-Taiwan independence party. Few in the PRC seem to be in a mood to hear anything good about Taiwan. In one Wechat forum for senior executives, the language turned sharp. “China has many such companies, you as a foreigner just don’t know about them.” Or, “Largan is only successful because like Taiwan itself, it is protected by the American government” and “Apple buys from Largan because it wants to hold back China’s development”.

Not a single comment I’ve seen focused on perhaps more obvious reasons China’s tech ambitions are proving so hard to realize: a weak system of patent protection, widespread online censoring and restrictions on free flow of information, a venture capital industry which, though now large, has an aversion to backing new directions in R&D.  In Taiwan, none of this is true.

Largan is doing so well because the optical-quality plastic lenses it makes for mobile phone cameras are unrivalled in their price and performance. Any higher-end mobile phone, be it an iPhone or an Android phone selling for above $400, relies on Largan lenses.

Many companies in the PRC have tried to get into this business. So far none have succeeded. Largan, of course, wants to keep it that way. It has factories in China, but key parts of Largan’s valuable, confidential manufacturing processes take place in Taiwan. High precision, high megapixel plastic camera lenses are basically impossible to reverse-engineer. You can’t simply buy a machine, feed in some plastic pellets and out comes a perfect, spherical, lightweight 16-megapixel lens. Largan has been in the plastic lens business for almost twenty years. Today’s success is the product of many long years of fruitless experimentation and struggle. Largan had to wait a long time for the market demand to arrive. Great companies, ones with high margins and unique products, generally emerge in this way.

We wrote the article in part because Largan is not widely-known in China. It should be. The PRC is, as most people know, engaged in a massive, well-publicized multi-pronged effort to stimulate high-tech innovation and upgrade the country’s manufacturing base. A huge rhetorical push from China’s central government leadership is backed up with tens of billions of dollars in annual state subsidies. Largan is a good example close to home of what China stands to gain if it is able to succeed in this effort. It’s not only about fat profits and high-paying jobs. Largan is also helping to create a lager network of suppliers, customers and business opportunities outside mobile phones. High precision low-cost and lightweight lenses are also finding their way into more and more IOT devices. There are also, of course, potential military applications.

So why is it, the article asks but doesn’t answer, the PRC does not have companies like Largan? Is it perhaps too early? From the comments I’ve seen, that is one main explanation. Give China another few years, some argued, and it will certainly have dozens of companies every bit as dominant globally and profitable as Largan. After all, both are populated by Chinese, but the PRC has 1.35 billion of them compared to 23 million on Taiwan.

A related strand, linked even more directly to notions of national destiny and pride: China has 5,000 years of glorious history during which it created such technology breakthroughs as paper, gunpowder, porcelain and the pump. New products now being developed in China that will achieve breakthroughs of similar world-altering amplitude.

Absent from all the comments is any mention of fundamental factors that almost certainly inhibit innovation in China. Start with the most basic of all: intellectual property protection, and the serious lack thereof in China. While things have improved a bit of late, it is still far too easy to copycat ideas and products and get away with it. There are specialist patent courts now to enforce China’s domestic patent regime. But, the whole system is still weakly administered. Chinese courts are not fully independent of political influence. And anyway, even if one does win a patent case and get a judgment against a Chinese infringer, it’s usually all but impossible to collect on any monetary compensation or prevent the loser from starting up again under another name in a different province.

Another troubling component of China’s patent system: it awards so-called “use patents” along with “invention patents”. This allows for a high degree of mischief. A company can seek patent protection for putting someone else’s technology to a different use, or making it in a different way.

It’s axiomatic that countries without a reliable way to protect valuable inventions and proprietary technology will always end up with less of both. Compounding the problem in China, non-compete and non-disclosure agreements are usually unenforceable. Employees and subcontractors pilfer confidential information and start up in business with impunity.

Why else is China, at least for now, starved of domestic companies with globally-important technology? Information of all kinds does not flow freely, thanks to state control over the internet. A lot of the coolest new ideas in business these days are first showcased on Youtube, Twitter, Instagram, Snapchat. All of these, of course, are blocked by the Great Firewall of China, along with all kinds of traditional business media. Closed societies have never been good at developing cutting edge technologies.

There’s certainly a lot of brilliant software and data-packaging engineering involved in maintaining the Great Firewall. Problem is, there’s no real paying market for online state surveillance tools outside China. All this indigenous R&D and manpower, if viewed purely on commercial terms, is wasted.

The venture capital industry in China, though statistically the second-largest in the world, has shunned investments in early-stage and experimental R&D. Instead, VCs pour money into so-called “C2C” businesses. These “Copied To China” companies look for an established or emerging business model elsewhere, usually in the US, then create a local Chinese version, safe in the knowledge the foreign innovator will probably never be able to shut-down this “China only” version. It’s how China’s three most successful tech companies – Alibaba, Tencent and Baidu – got their start. They’ve moved on since then, but “C2C” remains the most common strategy for getting into business and getting funded as a tech company in China.

Another factor unbroached in any of the comments and criticisms I read about the Largan article: universities in China, especially the best ones, are extremely difficult to get into. But, their professors do little important breakthrough research. Professorial rank is determined by seniority and connections, less so by academic caliber. Also, Chinese universities don’t offer, as American ones do, an attractive fee-sharing system for professors who do come up with something new that could be licensed.

Tech companies outside China finance innovation and growth by going public. Largan did so in Taiwan, very early on in 2002, when the company was a fraction of its current size. Tech IPOs of this kind are all but impossible in China. IPOs are tightly managed by government regulators. Companies without three years of past profits will never even be admitted to the now years-long queue of companies waiting to go public.

Taiwan is, at its closest point, only a little more than a mile from the Chinese mainland. But, the two are planets apart in nurturing and rewarding high-margin innovation. Taiwan is strong in the fundamental areas where the PRC is weak. While Largan may now be the best performing Taiwanese high-tech company, there are many others that similarly can run circles around PRC competitors. For all the recent non-stop talk in the PRC about building an innovation-led economy, one hears infrequently about Taiwan’s technological successes, and even less about ways the PRC might learn from Taiwan.

That said, I did get a lot of queries about how PRC nationals could buy Largan shares. Since the article appeared, Largan’s shares shot up 10%, while the overall Taiwan market barely budged.

Our Largan article clearly touched a raw nerve, at least for some. If it is to succeed in transforming itself into a technology powerhouse, one innovation required in China may be a willingness to look more closely and assess more honestly why high-tech does so much better in Taiwan.

(An English-language version of the Largan article can be read by clicking here. )

(财经杂志 Caijing Magazine’s Chinese-language article can be read by clicking here.)

http://blogs.ft.com/beyond-brics/2016/06/07/why-taiwan-is-far-ahead-of-mainland-china-in-high-tech/

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Outbid, outspent and outhustled: How Renminbi funds took over Chinese private equity (Part 1) — SuperReturn Commentary

1 Comment / August 12, 2020

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Outbid, outspent and outhustled

Renminbi-denominated private equity funds basically didn’t exist until about five years ago. Up until that point, for ten golden years, China’s PE and VC industry was the exclusive province of a hundred or so dollar-based funds: a mix of global heavyweights like Blackstone, KKR, Carlyle and Sequoia, together with pan-Asian firms based in Hong Kong and Singapore and some “China only” dollar general partners like CDH, New Horizon and CITIC Capital. These firms all raised money from much the same group of larger global limited partners (LPs), with a similar sales pitch, to make minority pre-IPO investments in high-growth Chinese private sector companies then take them public in New York or Hong Kong.

All played by pretty much the same set of rules used by PE firms in the US and Europe: valuations would be set at a reasonable price-to-earnings multiple, often single digits, with the usual toolkit of downside protections. Due diligence was to be done according to accepted professional standards, usually by retaining the same Big Four accounting firms and consulting shops doing the same well-paid helper work they perform for PE firms working in the US and Europe. Deals got underwritten to a minimum IRR of about 25%, with an expected hold period of anything up to ten years.

There were some home-run deals done during this time, including investments in companies that grew into some of China’s largest and most profitable: now-familiar names like Baidu, Alibaba, Pingan, Tencent. It was a very good time to be in the China PE and VC game – perhaps a little too good. Chinese government and financial institutions began taking notice of all the money being made in China by these offshore dollar-investing entities. They decided to get in on the action. Rather than relying on raising dollars from LPs outside China, the domestic PE and VC firms chose to raise money in Renminbi (RMB) from investors, often with government connections, in China. Off the bat, this gave these new Renminbi funds one huge advantage. Unlike the dollar funds, the RMB upstarts didn’t need to go through the laborious process of getting official Chinese government approval to convert currency. This meant they could close deals far more quickly.

Stock market liberalization and the birth of a strategy

Helpfully, too, the domestic Chinese stock market was liberalized to allow more private sector companies to go public. Even after last year’s stock market tumble, IPO valuations of 70X previous year’s net income are not unheard of. Yes, RMB firms generally had to wait out a three-year mandated lock-up after IPO. But, the mark-to-market profits from their deals made the earlier gains of the dollar PE and VC firms look like chump change. RMB funds were off to the races.

Almost overnight, China developed a huge, deep pool of institutional money these new RMB funds could tap. The distinction between LP and GP is often blurry. Many of the RMB funds are affiliates of the organizations they raise capital from. Chinese government departments at all levels – local, provincial and national – now play a particularly active role, both committing money and establishing PE and VC funds under their general control.

For these government-backed PE firms, earning money from investing is, at best, only part of their purpose. They are also meant to support the growth of private sector companies by filling a serious financing gap. Bank lending in China is reserved, overwhelmingly, for state-owned companies.

A global LP has fiduciary commitments to honor, and needs to earn a risk-adjusted return. A Chinese government LP, on the other hand, often has no such demand placed on it. PE investing is generally an end-unto-itself, yet another government-funded way to nurture China’s economic development, like building airports and train lines.

Chinese publicly-traded companies also soon got in the act, establishing and funding VC and PE firms of their own using balance sheet cash. They can use these nominally-independent funds to finance M&A deals that would otherwise be either impossible or extremely time-consuming for the listed company to do itself. A Chinese publicly-traded company needs regulatory approval, in most cases, to acquire a company. An RMB fund does not.

The fund buys the company on behalf of the listed company, holding it while the regulatory approvals are sought, including permission to sell new shares to raise cash. When all that’s completed, the fund sells the acquired company at a nice mark-up to its listed company cousin. The listco is happy to pay, since valuations rise like clockwork when M&A deals are announced. It’s called “market cap management” in Chinese. If you’re wondering how the fund and the listco resolve the obvious conflicts of interest, you are raising a question that doesn’t seem to come up often, if at all.

Peter continues his discussion of the growth of Renminbi funds next week. Stay tuned! He also moderates our SuperReturn China 2016 Big Debate: ‘How Do You Best Manage Your Exposure To China?’.

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http://www.superreturnlive.com/

Going for broke: the PE world’s big risky bet on China’s internet and mobile industries

Leave a Comment / June 18, 2014

China fortune-teller–

The World Cup has begun. Along with being the globe’s most watched event it is also certainly the most gambled upon. Thirty-two teams, sixty-four matches to determine the winner on July 13th in Rio de Janiero. To choose the winner, you want to look at the individuals, the team management, the history of past success, the competition. In other words, it’s a lot like the process a private equity or venture capital firm uses to choose which companies to invest in.

It would be ill-advised, if not borderline crazy, to bet one’s life savings on the USA team to win the World Cup this year. Coral, the big British bookmaker itself owned by three PE firms, is offering odds of four hundred to one.

While no one is offering odds or a betting pool, the current mania among PE firms in China for investing in loss-making internet and mobile services businesses looks like an even wilder bet. Herd behavior is a familiar enough phenomenon across the PE and VC world. But, the situation in China has reached almost comical proportions. At the moment, there is little, if any, PE money going to large, profitable, mature, comparatively “de-risked” manufacturing companies. Instead, almost all the publicly-announced deals are investments in a variety of mainly online shopping sites or mobile-phone travel, game and taxi-booking services, none of which has a true technological barrier to entry, and all of which seem to hinge mainly on the same prayed-for low-probability outcome: a purchase down the road by China’s two internet leviathans, Tencent or Alibaba.

A US IPO is also at least theoretically possible. This year has already seen successful IPOs for Chinese internet and mobile companies, including Zhaopin, Cheetah Mobile, Qihoo 360, Leju, Chukong Technologies, Sina Weibo, Tuniu. But, deals being done now are for smaller, newer less well-established China companies that mainly face a steep failure-filled mountain climb of at least two to three years to even reach a point at which an IPO in New York might even be possible.

It is true that China’s online shopping and services industry is booming. Problem is, almost all the money is being earned by these same two large firms. In online shopping, 80% goes to Alibaba. In online gaming, a far smaller money-maker, Tencent is about as dominant. Both have done a few deals in the last year, buying out or investing alongside PE firms in smaller Chinese companies which have gained some traction. At the same time a few Chinese internet companies have gone public in the US and Hong Kong. But, the overall environment is much less positive. There are far too many “me too” businesses with business models copy-catted from the US pouring out PE and VC cash to buy customers or a thin allotment of a 20 year-old Chinese male’s online gaming budget.

China is the world’s best mass manufacturer with the world’s largest, or second-largest, domestic market in just about every imaginable category. Simply put: there are so many better, less risky, more defended Chinese companies out there than the ones now getting most of the PE and VC time and money.

My bet is that Tencent and Alibaba will also soon lose their appetite for buying smaller Chinese internet players. They are at a similar phase as companies like Amazon, Google, eBay, Cisco, Microsoft, Electronic Arts, IAC/InterActiveCorp, once were. These giants at one time bought small US internet companies by the bucket-load. But, most have either quit or cut back doing so. The businesses usually fail to prosper, are non-core, and prove hard to integrate. Minority deals usually turn out worse. Corporate investors make bad VCs.

In other key respects, there is every difference in the world between the US VC scene and this current activity in China. The US has far more trade buyers for successful VC-backed companies, far more genuine innovation, far more success stories, far less monopolistic internet and mobile industries, and a far richer “early adaptor” market to tap. You don’t need to look back very far to see where this kind of investing activity can lead. It’s only a little more than two years since PE firms poured hundreds of millions of Renminbi into Chinese group shopping sites modeled to some extent on US Groupon. Almost all these companies are now out of business or losing serious money. Chinese like group-buying. They just don’t let any company make any money from offering such a service.

Scan through the last three weekly summaries of new PE and VC deals in China, as digested by Asia Private Equity in Hong Kong. Virtually all involve deals to invest in online and mobile services. (Click here to look at the list of these deals.)

I talk or meet with PE partners on a regular basis. I can recall only a single discussion, over the last six months, where the PE firm’s primary focus was not on these kind of deals. This lonesome PE is the captive fund of one of China’s largest state-owned automobile groups. At this stage, about as differentiated as Chinese PE investment gets is whether the money should go into one of the many online sites for takeaway meals or one of the even larger number selling cosmetics.

China PE is slowly emerging from a prolonged period of inactivity and crisis, the result of both a slowdown in IPO activity and PE portfolios bloated with unexited deals. It’s good to see some sign of animal spirits again, that some PE firms at least are looking to do deals. But at least up to now, it looks like some bad old habits are being repeated: too many PE firms enslaved to the same investment thesis, chasing the same few companies, bidding up their valuations, inadequate diversification by industry or stage.

In the US, in most VC-backed companies, one of the busiest members of senior management is the head of business development. This job is often to find strategic partnerships, barter and co-bundling deals to generate more growth at less expense. This kind of thing is much rarer in China. Instead, for most, the primary method of customer acquisition is to spend a lot of money on Baidu advertising.

Baidu is far more accommodating than Google. It’s the dirty, not-so-well-kept secret of China’s internet industry. Baidu, which handles over 60% of all Chinese search requests, lets advertisers buy placement on the first page of what are called  “organic search results”. There is basically no such thing in China as “most relevant” search results. The only search algorithm is: “who has paid us the most”. It’s one reason Google’s pullback from the China market is so damaging overall for the Chinese internet.

The “pay to play” rules in China’s internet leads to companies taking lots of expensive short cuts, often using PE and VC firm cash. There’s more than a little here to remind me of the Internet Bubble years in the US. I ended up running a VC firm in California right after the bubble burst. I still shake my head at some of the deals this VC firm invested in before I got there, when, as is now in China, pouring lots of LP money in any kind of dot.com or shopping site was seen as prudent fiduciary investing. Things turned out otherwise. They turned out messy. They will too with this PE infatuation with online and mobile anything in China. A bet on the USA to win the World Cup offers more attractive odds and upside.

 

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.

 

 

 

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.

 

 

Will Bad Money Drive Out Good in Chinese Private Equity?

2 Comments / December 1, 2009

Qing Dynasty jade boulder, from China First Capital blog post

The financial rule first postulated by Sir Thomas Gresham 500 years ago famously holds that “bad money drives out good”. In other words, if two different currencies are circulating together, the “bad” one will be used more frequently. By “bad”, what Gresham meant was a currency of equal face value but lower real value than its competitor. A simple way to understand it: if you had two $100 bills in your wallet, and suspected one is counterfeit and the other genuine, you’d likely try to spend the counterfeit $100 bill first, hoping you can pass it off at its nominal value. 

While it’s a bit of a stretch from Sir Thomas’s original precept, it’s possible to see a modified version of Gresham’s Law beginning to emerge in the private equity industry in China. How so? Money from some of “bad” PE investors may drive out money from “good” PE investors. If this happens, it could result in companies growing less strongly, less solidly and, ultimately, having less successful IPOs. 

Good money belongs to the PE investors who have the experience, temperament, patience, connections, managerial knowledge and financial techniques to help a company after it receives investment. Bad money, on the other hand, comes from private equity and other investment firms that either cannot or will not do much to help the companies it invests in. Instead, it pushes for the earliest possible IPO. 

Good money can be transformational for a company, putting it on a better pathway financially, operationally and strategically. We see it all the time in our work: a good PE investor will usually lift a company’s performance, and help implement long-term improvements. They do it by having operational experience of their own, running companies, and also knowing who to bring in to tighten up things like financial controls and inventory management. 

You only need to look at some of China’s most successful private businesses, before and after they received pre-IPO PE finance, to see how effective this “good money” can be. Baidu, Suntech, Focus Media, Belle and a host of the other most successful fully-private companies on the stock market had pre-IPO PE investment. After the PE firms invested, up to the time of IPO, these companies showed significant improvements in operating and financial performance. 

The problem the “good money” PEs face in China is that they are being squeezed out by other investors who will invest at higher valuations, more quickly and with less time and money spent on due diligence. All money spends the same, of course. So, from the perspective of many company bosses, these firms offering “bad money” have a lot going for them. They pay more, intrude less, demand little. Sure, they don’t have the experience or inclination to get involved improving a company’s operations. But, many bosses see that also as a plus. They are usually, rightly or wrongly,  pretty sure of themselves and the direction they are moving. The “good money” PE firms can be seen as nosy and meddlesome. The “bad money” guys as trusting and fully-supportive. 

Every week, new private equity companies are being formed to invest in China – with billions of renminbi in capital from government departments, banks, state-owned companies, rich individuals. “Stampede” isn’t too strong a word. The reason is simple: investing in private Chinese companies, ahead of their eventual IPOs, can be a very good way to make money. It also looks (deceptively) easy: you find a decent company, buy their shares at ten times this year’s earnings, hold for a few years while profits increase, and then sell your shares in an IPO on the Shanghai or Shenzhen stock markets for thirty times earnings. 

The management of these firms often have very different backgrounds (and pay structures) than the partners at the global PE firms. Many are former stockbrokers or accountants, have never run companies, nor do they know what to do to turn around an investment that goes wrong. They do know how to ride a favorable wave – and that wave is China’s booming domestic economy, and high profit growth at lots of private Chinese companies. 

Having both served on boards and run companies with outside directors and investors, I am a big believer in their importance. Having a smart, experienced, active, hands-on minority investor is often a real boon. In the best cases, the minority investors can more than make up for any value they extract (by driving a hard bargain when buying the shares) by introducing more rigorous financial controls, strategic planning and corporate governance. The best proof of this: private companies with pre-IPO investment from a “good money” PE firm tend to get higher valuations, and better underwriters, at the time of their initial public offering. 

But, the precise dollar value of “good money” investment is hard to measure. It’s easy enough for a “bad money” PE firm to claim it’s very knowledgeable about the best way to structure the company ahead of an IPO.  So, then it comes back to: who is willing to pay the highest price, act the quickest, do the most perfunctory due diligence and attach the fewest punitive terms (no ratchets or anti-dilution measures) in their investment contracts. In PE in China, bad money drives out the good, because it drives faster and looser.

How to Time an IPO – the Right Path to the Stock Market for a Strong Chinese SME

Leave a Comment / June 4, 2009

Ching Dynasty snuff bottle in China First Capital blog post

 

The timing of IPO is the most important question for all Chinese SME preparing for a public listing. Unfortunately, the correct answer is often the one most rarely heard. Instead, many investment bankers and advisors in China tell the SME boss that an IPO should be scheduled “as soon as possible”.

This is often music to the bosses untrained ears, since they’re wrongly assuming that the proceeds of an IPO will go directly into their pockets – a misconception these same investment bankers and advisors can literally cash in on. They’ll tell the SME boss the “bad” news — that the IPO proceeds must go to the company not to his personal bank account, and that the boss won’t be able to sell any of his own shares for a year or more after the IPO – towards the end of the expensive pre-IPO planning process, when it’s usually too late to pull out, without losing a huge amount of money.

This is if they bother to mention it at all. I’ve heard of instances where the Chinese boss is never told directly by his investment bankers, lawyers and advisors, but only finds out if his staff prepares a Chinese translation of the SB-2 prospectus used in OTCBB listings.

So, if not “right away”, what is the correct answer to the question: “when should a Chinese SME IPO”? Of course, circumstances will differ for each company. But, as a general principle, an IPO should come at the apex of an SME’s growth curve, when the company is achieving its historical highest return on equity and return on investment. This way, the SME will get a fuller value for its shares when it does list them publicly.

This also explains why pre-IPO private equity can have such a key role to play in the process. The purpose: put more capital to work than the company can generate internally, or can borrow from banks. This equity capital is then invested where it will earn the highest return over a two to three year period – for example, increasing production and improving economies of scale, or accelerating the pace of opening new distribution outlets.

The PE firm will also help improve efficiencies – in their role as risk-sharing partner with the SME boss – that can lead to significant improvement in net margins. In most cases, the pre-IPO PE capital can result in a doubling of profits. Done right, the pre-IPO capital will result in only modest level of dilution for existing owners – usually no more than 25%. It’s like switching on the after-burners: the SME can speed up its growth, improve its margins, seize large available market opportunities, and so position itself for a far more successful IPO in two to three years’ time.

An IPO has one great value above everything else: it will be the cheapest and most efficient way for an SME to raise the capital it needs to expand its business. The shares will likely be valued at multiples two times higher than a pre-IPO PE investor will pay. Since the amount of capital raised will be a multiple of profits, the higher the profits at IPO the better.

To illustrate this, let’s imagine a company with profits last year of RMB75 million. It has its IPO now, at a PE of 15 and its market capitalization at IPO is RMB 1,125,000,000. The company sells 25% of its shares in the IPO, and so it raises RMB 281,250,000. If instead the company waits another year, it raises a RMB50 million of pre-IPO private equity to help push its profit growth. A year later, profits have reached RMB120 million. If the company now has its IPO, at the same PE of 15, and sells 25% of the shares, it will raise RMB450,000,000 or 60% more.

Let’s  assume  the company continues to maintain a high return-on-investment, after IPO. If so, the more money raised at IPO, the higher profits should be able grow in the future. This is perhaps the most important predictor of overall share performance after IPO. By waiting to IPO, so that its size and profits would be larger, this company will be able to raise much more at IPO and so continue generate higher profits for many years into the future.

A company can IPO only once. So, it is important to raise the optimal amount during this one IPO. If a company IPOs too early, it will sacrifice its ability to finance its growth in the future. Many of the most successful IPOs in China were for private SME companies that had pre-IPO investment from private equity companies: Baidu, Alibaba, Suntech, Belle. That isn’t a coincidence. It’s the result of the sort of smart IPO-planning that is too rare in China.

 

 

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