Carlyle

Goldman, Lazard China Dealmakers Decamp for Upstart Funds — Bloomberg

(Bloomberg) — Veteran China dealmakers at Wall Street banks and Western buyout firms are heading for the exits, in search of the more lucrative deals and higher remuneration offered by smaller funds.

Three senior merger advisory bankers from Goldman Sachs Group Inc., Bank of America Corp. and Lazard Ltd. have resigned within the past month for senior roles at fledgling investment funds, according to people familiar with their departures, who asked not to be identified discussing private information. Carlyle Group LP Managing Director Alex Ying left the firm in January after two decades to set up Rivendell Partners, which focuses on mid-sized buyouts in Greater China and Vietnam, other people said.

The moves highlight the increasing challenges big banks face in retaining their top dealmakers in an environment of tighter regulations and shrinking fees. Revenue from investment banking in the Asia Pacific region fell 8 percent in 2016 to the lowest in at least five years, according to data from research firm Coalition. Merger advisory revenue dropped 4 percent, the figures show.

“Deal flow from China has come down considerably — those flows are severely curtailed relative to where they were,” said Henry Tillman, chairman of London-based advisory firm Grisons Peak LLP. “With investment banking revenue declining, people are going to look at their options.”

Imminent departures include Andrew Huang, a managing director advising on Greater China mergers and acquisitions at Goldman Sachs who has resigned to join Chinese private equity firm FountainVest Partners, according to the people. Peter Kuo, a China M&A banker at Lazard, is leaving to help run a technology fund backed by Chinese investors called Canyon Bridge Capital Partners, the investment firm confirmed in response to Bloomberg queries.

Higher Returns

Ellis Chu, head of China M&A at Bank of America, has also resigned and will be joining an Asia-focused fund, the people said.

Spokesmen for Bank of America, Goldman Sachs and Rivendell declined to comment on the departures. A representative for Carlyle confirmed Ying’s departure, declining to comment further. FountainVest Chief Executive Officer Frank Tang didn’t answer calls to his mobile phone seeking comment.

Running or working for a smaller, Asia-based fund can offer managers greater independence in decision-making on deals and give them a bigger share of fees and profits from exiting investments. Senior executives at global buyout funds in Asia typically have to share 40 percent to 60 percent of deal fees generated in the region with U.S. and European counterparts, people familiar with the practice said.

Smaller funds are also making more money. Private funds in Asia with assets of $500 million or less had a median internal rate of return of 16.1 percent over a three-year timeframe, compared with 11.5 percent at peers with more than $1 billion of assets, according to data compiled by research firm Preqin Ltd.

High Turnover

“A reason these guys are leaving likely also includes the fact those big firms have been having a challenging time of late in China, which leads to higher work pressure and unusually high turnover,” said Peter Fuhrman, chairman of Shenzhen-based China First Capital. “You can then try to set up on your own, make some deals, hope for success.”

The exits follow other recent moves to smaller outfits. KKR & Co.’s two most senior China executives left in December to form a China-focused investment firm. Richard Wong, an M&A veteran at Morgan Stanley, resigned this month after 16 years to help set up Nexus Point Partners, a China-focused buyout fund started by MBK Partners Ltd. co-founder Kuo-Chuan Kung.

The bankers and their new funds will face challenges when it comes to sourcing China deals. The government is clamping down on money outflows, which augurs poorly for outbound acquisitions. What’s more, competition is increasing from Chinese securities firms. Three Chinese banks ranked in the top 10 advisers on offshore acquisitions by mainland companies since the beginning of 2016, according to data compiled by Bloomberg.

Among the first buyout specialists to make the leap from big outfits were KY Tang, who left UBS AG’s private equity fund in 2004 to start Affinity Equity Partners, and Michael Kim, who set up MBK in 2005 with five other senior Asian executives from Carlyle. In 2010, TPG Capital lost Shan Weijian, who left to found PAG Asia Capital. The next year, Mary Ma departed to help start Boyu Capital.

https://www.bloombergquint.com/markets/2017/03/30/veteran-china-dealmakers-leave-wall-street-for-upstart-funds

Chinese Firms Are Reinventing Private Equity — Nikkei Asian Review

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Pudong

July 26, 2016  Commentary

Chinese firms are reinventing private equity

Henry Kravis, his cousin George Roberts and his mentor Jerry Kohlberg are generally credited with having invented private equity buyouts after forming KKR 40 years ago. Even after other firms like Blackstone and Carlyle piled in and deals reached mammoth scale, the rules of the buyout game changed little: Select an underperforming company, buy it with lots of borrowed money, cut costs and kick it into shape, then sell out at a big markup, either in an initial public offering or to a strategic buyer.

This has proved a lucrative business that lots of small private equity firms worldwide have sought to copy. China’s domestic buyout funds, however, are trying to reinvent the PE buyout in ways that Kravis would barely recognize. Instead of using fancy financial engineering, leverage and tight operational efficiencies to earn a return, the Chinese firms are counting on Chinese consumers to turn their buyout deals into moneymakers.

Compared to KKR and other global giants, Chinese buyout firms are tiny, new to the game and little known inside China or out. Firms such as AGIC, Golden Brick, PAG, JAC and Hua Capital have billions of dollars at their disposal to buy international companies. Within the last year, these five have successfully led deals to acquire large technology and computer hardware companies in the U.S. and Europe, including the makers of Lexmark printers, OmniVision semiconductors and the Opera web browser.

So what’s up here? The Chinese government is urgently seeking to upgrade the country’s manufacturing and technology base. The goal is to sustain manufacturing profits as domestic costs rise and sales slow worldwide for made-in-China industrial products. The government is pouring money into supporting more research and development. It is also spreading its bets by providing encouragement and sometimes cash to Chinese investment companies to buy U.S. and European companies with global brands and valuable intellectual property.

While the hope is that acquired companies will help China move out of the basement of the global supply chain, the buyout funds have a more immediate goal in sight, namely a huge expansion of the acquired companies’ sales within China.

This is where the Chinese buyout firms differ so fundamentally from their global counterparts. They aren’t focusing much on streamlining acquired operations, shaving costs and improving margins. Instead, they plan to leave things more or less unchanged at each target company’s headquarters while seeking to bolt on a major new source of revenues that was either ignored or poorly managed.

So for example, now that the Lexmark printer business is Chinese-owned, the plan will be to push growth in China and capture market share from domestic manufacturers that lack a well-known global brand and proprietary technologies. With OmniVision Technologies, the plan will be to aggressively build sales to China’s domestic mobile phone producers such as Huawei Technologies, Oppo Electronics and Xiaomi.

The China Android phone market is the biggest in the world.  Omnivision used to be the main supplier of mobile phone camera sensor chips to the Apple iPhone, but lost much of the business to Sony.

In launching last year the $1.8bn takeover of then then Nasdaq-quoted Omnivision, Hua Capital took on significant and unhedgeable risk. The deal needed the approval of the US Committee for Foreign Investment in the United States, also known as CFIUS. This somewhat-shadowy interagency body vets foreign takeovers of US companies to decide if US national security might be compromised. CFIUS has occasionally blocked deals by Chinese acquirers where the target had patents and other know-how that might potentially have non-civilian applications.

CFIUS also arrogates to itself approval rights over takeovers by Chinese companies of non-US businesses, if the target has some presence in the US. It used this justification to block the $2.8 billion takeover by Chinese buyout fund GO Scale Capital of 80% of the LED business of Netherlands-based Philips. CFIUS acted almost a year after GO Scale and Philips first agreed to the deal. All the time and money spent by GO Scale with US and Dutch lawyers, consultants and accountants to conclude the deal went down the drain. CFIUS rulings cannot be readily appealed.

Worrying about CFIUS approval isn’t something KKR or Blackstone need do, but it’s a core part of the workload at Chinese buyout funds. Hua Capital ultimately got the okay to buy Omnivision five months after announcing the deal to the US stock exchange.

The Chinese buyout firms see their role as encouraging and assisting acquired companies to build their business in China. This often boils down to business development and market access consulting. Global buyout firms say they also do some similar work on behalf of acquired companies, but it is never their primary strategy for making a buyout financially successful.

Chinese buyout funds count on two things happening to make a decent return on their overseas deals. First is a boost in revenues and profits from China. Second, the funds have to sell down their stake for a higher price than they paid. The favored route on paper has been to seek an IPO in China where valuations can be the highest in the world. This path always had its complications since it generally required a minimum three-year waiting period before submitting an application to join what is now a 900-company-long IPO waiting list.

The IPO route has gotten far more difficult this year. The Chinese government delivered a one-two punch, first scrapping its previous plan to open a new stock exchange board in Shanghai for Chinese-owned international companies, then moving to shut down backdoor market listings through reverse mergers.

The main hope for buyout funds seeking deal exits now is to sell to Chinese listed companies. In some cases, the buyout funds have enlisted such companies from the start as minority partners in their company takeovers. This isn’t a deal structure one commonly runs across outside China, but may prove a brilliant strategy to prepare for eventual exits.

There is one other important way in which the new Chinese buyout funds differ from their global peers. They don’t know the meaning of the term “hostile takeover.” Chinese buyout funds seek to position themselves as loyal friends and generous partners of a business’s current owners. A lot of sellers, especially among family-controlled companies in Europe, say they prefer to sell to a gentle pair of hands — someone who promises to build on rather than gut what they have put together. Chinese buyout funds sing precisely this soothing tune, opening up some deal-making opportunities that may be closed to KKR, Blackstone, Carlyle and other global buyout giants.

The global firms are also finding it harder to compete with Chinese buyout funds for deals within China, even though they have raised more than $10 billion in new funds over the last six years to put into investments in the country. They have basically been shut out of the game lately because they can’t and won’t bid up valuations to the levels to which domestic funds are willing to go.

The global buyout giants won’t be too concerned that they face an existential threat from their new Chinese competitors. It is also unlikely that they will adopt similar deal strategies. Instead, they are getting busy now prettying up companies they have previously bought in the U.S. and Europe. They will hope to sell some to Chinese buyers. Along with offering genial negotiations and a big potential market in China, the Chinese buyout funds are also gaining renown for paying large premiums on every deal. No one ever said that about Henry Kravis.

Peter Fuhrman is the founder, chairman and CEO of China First Capital, an investment bank based in Shenzhen.

Abridged version as published in Nikkei Asian Review

How Renminbi funds took over Chinese private equity (Part 2) — SuperReturn Commentary

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How Renminbi funds took over Chinese private equity

(Part 2)

 
Large and small ships traverse the Huangpu River 24 hours a day, 7 days a week, and 365 days a year.

Part two of a series. Read part one.

Gresham’s Law, as many of us were taught a while back, stipulates that bad money drives out good. There’s something analogous at work in China’s private equity and venture capital industry. Only here it’s not a debased currency that’s dominating transactions. Instead, it’s Renminbi private equity (PE) firms. Flush with cash and often insensitive to valuation and without any clear imperative to make money for their investors, they are changing the PE industry in China beyond recognition and making life miserable for many dollar-based PE and venture capital (VC) firms.

Outbid, outspent and outhustled

From a tiny speck on the PE horizon five years ago, Reminbi (RMB) funds have quickly grown into a hulking presence in China. In many ways, they now run the show, eclipsing global dollar funds in every meaningful category – number of active funds, deals closed and capital raised. RMB funds have proliferated irrespective of the fact there have so far been few successful exits with cash distributions.

The RMB fund industry works by a logic all its own. Valuations are often double, triple or even higher than those offered by dollar funds. Term sheets come in faster, with fewer of the investor preferences dollar funds insist on. Due diligence can often seem perfunctory.  Post-deal monitoring? Often lax, by global standards. From the perspective of many Chinese company owners, dollar PE firms look stingy, slow and troublesome.

The RMB fund industry’s greatest success so far was not the IPO of a portfolio company, but of one of the larger RMB general partners, Jiuding Capital. It listed its shares in 2015 on a largely-unregulated over-the-counter market called The New Third Board. For a time earlier this year, Jiuding had a market cap on par with Blackstone, although its assets under management, profits, and successful deal record are a fraction of the American firm’s.

The main investment thesis of RMB funds has shifted in recent years. Originally, it was to invest in traditional manufacturing companies just ahead of their China IPO. The emphasis has now shifted towards investing in earlier-stage Chinese technology companies. This is in line with China’s central government policy to foster more domestic innovation as a way to sustain long-term GDP growth.

The Shanghai government, which through different agencies and localities has become a major sponsor of new funds, has recently announced a policy to rebate a percentage of failed investments made by RMB funds in Shanghai-based tech companies. Moral hazard isn’t, evidently, as high on their list of priorities as taking some of the risk out of risk-capital investing in start-ups.

Dollar funds, in the main, have mainly been observing all this with sullen expressions. Making matters worse, they are often sitting on portfolios of unexited deals dating back five years or more. The US and Hong Kong stock markets have mainly lost their taste for PE-backed Chinese companies. While RMB funds seem to draw from a bottomless well of available capital, for most dollar funds, raising new money for China investing has never been more difficult.

RMB funds seldom explain themselves, seldom appear at industry forums like SuperReturn. One reason: few of the senior people speak English. Another: they have no interest or need to raise money from global limited partners. They have no real pretensions to expand outside China. They are adapted only and perhaps ideally to their native environment. Dollar funds have come to look a bit like dinosaurs after the asteroid strike.

Can dollar-denominated firms strike back?

Can dollar funds find a way to regain their central role in Chinese alternative investing? It won’t be easy. Start with the fact the dollar funds are all generally the slow movers in a big pack chasing the same sort of deals as their RMB brethren. At the moment, that means companies engaged in online shopping, games, healthcare and mobile services.

A wiser and differentiated approach would probably be to look for opportunities elsewhere. There are plenty of possibilities, not only in traditional manufacturing industry, but in control deals and roll-ups. So far, with few exceptions, there’s little sign of differentiation taking place. Read the fund-raising pitch for dollar and RMB funds and, apart from the difference in language, the two are eerily similar. They sport the same statistics on internet, mobile, online shopping penetration: the same plan to pluck future winners from a crop of look-alike money-losing start-ups.

There is one investment thesis the dollar PE funds have pretty much all to themselves. It’s so-called “delist-relist” deals, where US-quoted Chinese companies are acquired by a PE fund together with the company’s own management, delisted from the US market with the plan to one day IPO on China’s domestic stock exchange. There have been a few successes, such as the relisting last year of Focus Media, a deal partly financed by Carlyle. But, there are at least another forty such deals with over $20bn in equity and debt sunk into them waiting for their chance to relist. These plans suffered a rather sizeable setback recently when the Chinese central government abruptly shelved plans to open a new “strategic stock market” that was meant to be specially suited to these returnee companies. The choice is now between prolonged limbo, or buying a Chinese-listed shell to reverse into, a highly expensive endeavor that sucks out a lot of the profit PE firms hoped to make.

Outspent, outbid and outhustled by the RMB funds, dollar PE funds are on the defensive, struggling just to stay relevant in a market they once dominated. Some are trying to go with the flow and raise RMB funds of their own. Most others are simply waiting and hoping for RMB funds to implode.

So much has lately gone so wrong for many dollar PE and VC in China. Complicating things still further, China’s economy has turned sour of late. But, there’s still a game worth playing. Globally, most institutional investors are under-allocated to China.  A new approach and some new strategies at dollar funds are overdue.

Peter Fuhrman moderates our SuperReturn China 2016 Big Debate: ‘How Do You Best Manage Your Exposure To China?’. Discussants include:

  • John Lin, Managing Partner, NDE Capital (GP)
  • Xisheng Zhang, Founding Partner & President, Hua Capital (GP)
  • Bo Liu, Chief Investment Officer, Wanda Investment (LP)
The Big Debate takes place on Tuesday 19 April 2016 at 11:55 – 12:25 at SuperReturn China in Beijing. Can’t make it? Follow the action on Twitter.

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

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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?’.

http://www.superreturnlive.com/

Why China PE will rise again — Interview in China Law & Practice Annual Review 2013

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Peter Fuhrman, chairman of China First Capital, talks to David Tring about his company’s disciplined focus, what the IPO freeze means for PE investors and how a ruling from a court in China has removed a layer of safety for PE firms

What is China First Capital?

China First Capital is a China-focused international bank and advisory firm. I am its chairman and founder. Establishing, and now running, China First Capital is the fulfilment of a deeply-held ambition nurtured for over 30 years. I first came to China in 1981, as part of a first intake of American graduate students in China. I left China after school and then built a career in the US and Europe. But, throughout, I never lost sight of the goal to return to China and start a business that would contribute meaningfully and positively to the country’s revival and prosperity.

China First Capital is small by investment banking industry standards. Our transaction volume over the preceding twelve months was around $250 million. But, we aim to punch above our weight. China First Capital’s geographical reach and client mandates are across all regions of China, with exceptional proprietary deal flow. We have significant domain expertise in most major industries in China’s private and public sector, structuring transactions for a diversified group of companies and financial sponsors to help them grow and globalise. We seek to be a knowledge-driven company, committed to the long-term economic prosperity of Chinese business and society, backed by proprietary research (in both Chinese and English), that is generally unmatched by other boutique investment banks or advisory firms active in China.

What have been some of the legislative changes to the PE sector this year that are affecting you?

The recent policy and legislative changes are mainly no more than tweaks. There has been some sparring within China over which regulator would oversee private equity. But, overall, the PE industry in China is both lightly and effectively regulated. A key change, however, occurred through the legal system within China, when a court in Western China invalidated the put clause of a PE deal done within China, ruling that the PE firm involved had ignored China’s securities laws in crafting this escape mechanism for their investment.  While the court ruled on only a single example, the logic applied in this case seems to me, and many others, to be both persuasive and potentially broad-reaching. For PE firms that traditionally added this put clause to all contracts they signed to invest in Chinese companies, and came to rely on it as a way to compel the company to buy them out after a number of years if no IPO took place, there is now real doubt about whether a put clause is worth the paper it’s printed on. Simply put, for PE firms, it means their life-raft here in China has perhaps sprung a leak.

What are some of the hottest sectors in China that are attracting PE investors?

At the moment, with IPOs suspended within China and Chinese private companies decidedly unwelcome in the capital markets that once embraced them by the truckload – the US and Hong Kong – there are no hot sectors for PE investment in China now. The PE industry in China, once high-flying, is now decidedly grounded and covered in tarpaulin. What is perhaps most unfortunate about this is that what we are seeing mainly is a crisis within China’s PE industry, not within the ranks of China’s very dynamic private entrepreneurial economy. In other words, while financing has all but dried up, China’s private companies continue, in many cases, to excel and outperform those everywhere else in the world. The PE firms made a fundamental miscalculation by pouring money into too many deals where their only method of exit, of getting their money back with a profit, was through an IPO. By our count, there are now over 7,500 PE-invested deals in China all awaiting exit, at a time when few, if any exits are occurring. Since PE firms themselves have a finite life in almost all cases, this means over $100bn in capital is now stuck inside deals with no high-probability way to exit before the PE funds themselves reach their planned expiry. The PE industry has never seen anything quite like what is happening now in China.

What is a typical day like for you at China First Capital?

We are lucky to work for an outstanding group of companies, mainly all Chinese domestic. Indeed, I am the only non-Chinese thing about the business. I am in China doing absolutely what I love doing. There are no aspects of my working day that I find tedious or unpleasant. Even at my busiest, I am aware I am at most a few hours away from what the next in an endless series of totally delicious Chinese meals. That alone has a levitating effect on my spirit. But, the real source of pleasure and purpose is in befriending and working beside entrepreneurs who are infinitely more skilled, more driven and wiser to the ways of the world and more successful than I ever could hope to be.

We are quite busy now working for one of China’s largest SOEs. It’s something of a departure for us, since most of our work is with private sector companies. But, this is a fascinating transaction that provides me with a quite privileged insider’s view of the way a large state-owned business operates here in China, the additional layers of decision-making and the unique environment that places far greater onus on increasing revenues than profits.

What do you find are some of the major issues or concerns for foreign PE clients when doing deals in China?

All investors looking to make money in China, whether on the stock market or through private equity and venture capital,  must confront the same huge uncertainty – not that China itself will stop its remarkable economic transformation and stop growing at levels that leave the rest of the developed world behind in the dust. This growth I believe will continue for at least the next 20 years. The big unknown has to do with the actual situation inside the Chinese company you are buying into. Can the financial statements and Big Four audits be relied on? Are the actual profits what the company asserts them to be? How great is the risk that investors’ money will disappear down some unseen rat hole?

Some frightening stories have come to light in the last two years. How widespread is the problem of accounting fraud in China? Part of the problem really is just the law of big numbers. With a population almost triple that of the US and Western Europe combined, China has a lot of everything, including both remarkable businesses run by individuals who are the entrepreneurial equal of Henry Ford and Steve Jobs, and well as some shady operators.

What is your outlook for China’s PE sector in the coming 12 months?

I believe the current crisis will abate, and stock markets will once again welcome Chinese private sector companies to do IPOs. The IPOs will be far fewer in number than in 2010, but still the revival of IPO exits will also thaw the current deep-freeze that has shut down most PE activity across China. PE firms will again start to invest, and put a dent in the $30 billion or more in capital they have raised to invest in China but have left untouched. The PE industry in China, since its founding a little more than a decade ago, grew enormously large but never really matured. There are now too many PE firms. By some count, the number exceeds 1,000, including hundreds of Renminbi PE firms started and run by people with no real experience investing in private companies. Their future appears dire. At the same time, the global PE firms that bestride the industry, including Carlyle, Blackstone, TPG, KKR, have yet to fully establish they can operate as efficiently and profitably in China as they do in Europe and the US.

While the China PE industry struggles to recover from many self-inflicted wounds, China’s private sector companies will continue to find and exploit huge opportunities for growth and profit in China, as the nation’s one billion consumers grow ever-richer and ever more demanding.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

Taxed At Source: Renminbi Private Equity Firms Confront the Taxman

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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.

 

 

 

“Coincidence is God’s way of remaining anonymous” – Albert Einstein

Longquan vase from China First Capital blog post

Just about everyone has experienced a miraculous coincidence at least once in their lifetime, a chance encounter with a friend at a place and time where neither side would ever have expected to meet. I’ve had a few in my life. The most memorable was running into Giovanna, an old girlfriend of mine from when I was a graduate student at the Chinese University of Hong Kong. I literally bumped into her, eight years after losing touch (this was in the pre-email era) one morning at the bustlingly gorgeous Campo de’ Fiori vegetable market in the center of Rome.

We quickly got reacquainted, and she juggled me and her then-current boyfriend for awhile. I was a foreign correspondent for Forbes based in London. She was living in Rome, close to the market, one of my favorite spots in one of my favorite and most-visited cities in the world.

There was a high degree of improbability about that meeting in Rome. But, it wasn’t completely unfathomable, since she was an Italian, and even when I knew her, interested in film-making. Rome is the center of that industry in Italy. Giovanna had studied in China, spoke good Chinese and had landed a small job helping Bernardo Bertolucci shoot scenes in China for The Last Emperor.  She parlayed that into a friendship with the director and the producer of Last Emperor, and then found other work in the film business.

In Chengdu recently, I had an even more remarkable coincidental meeting than that one in Campo de’ Fiori. At a large and fancy restaurant there, a friend of mine from work, Nick Shao, who is a Managing Director of PE firm Carlyle in Shanghai, came up and greeted me as I sat down at a table with two people I only just met.

My brain circuitry is not what it used to be. It probably took me two to three seconds to actually figure out who Nick was and how I knew him. Then it clicked, of course, and I started burbling in my bad Chinese about how remarkable the whole thing was – why was he there? Doing what? Was the food any good?

Running into Nick was remarkable for a lot of reasons, including the fact I know a comparatively small number of people in China, had not been in Chengdu in 28 years, and was in a restaurant that seats at least 800 people. To end up at a table nearby to someone I knew, in a city of 11 million that neither of us have any connection to, in a country with the largest population in the world, that’s a level of unlikelihood that I can’t even begin to quantify. I’d be hard-pressed to find one of my own family members in that restaurant, it’s that large and crowded.

As I found out, Nick was in Chengdu for an EMBA course he’s taking. This also left me a little nonplussed, since I knew Nick already had an MBA from Columbia. Why would anyone need two? Why was his Shanghai university convening its class at a not-especially famous restaurant in Chengdu? I still don’t have solid answers to either of these questions, even after exchanging emails with Nick later that day.

For my part, I was in Chengdu to participate in a PE conference organized by the Sichuan government. I skipped the official lunch to meet some friends-of-friends. It would not be stretching things to say the last place I’d expect to meet someone I know would be that restaurant, in that city, in that country, at that date and time.

I had a great three days in Chengdu,  eating, chatting and walking around China’s most relaxed, pleasant and livable major city. Meeting Nick made it very much more memorable, just as I continue to remember, when I think of Rome, that meeting, over 20 years ago, in Campo de’ Fiori.

For me, at least, this coincidental meeting spurred a lot of what little I can muster in terms of philosophical reflection. It’s all hackneyed stuff, of course, but our lives really are created by the miracle of birth, and punctuated thereafter by occasional miracles, large and small. The world is, in its most benign state, the motive force for the coming true of every sort of wonderful, unexpected but thoroughly delightful possibility. Dreams come true. Happy coincidences occur.


Carlyle Goes Native: Renminbi Investing Gets Big Boost in China

 

Qing Dynasty lacquer box from China First Capital blog post

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.


Private Equity in China: Blackstone & Others May Grab the Money But Miss the Best Opportunities

China First Capital blog post -- Song Jun vase

Blackstone, the giant American PE firm, is now trying to raise its first renminbi fund. Its stated goal is to provide growth capital for China’s fast-growing companies. Blackstone isn’t the only international private equity firm seeking to raise renminbi to invest in China.  In fact, many of the world’s largest private equity firms, including those already investing in China using dollars, are looking to tap domestic Chinese sources for investment capital.

Dollar-based investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult, often impossible, and deals take longer to close than competing investors with access to renminbi.

Blackstone enjoys a big leg up in China over other international private equity firms looking to raise renminbi. Its largest institutional shareholder is China’s sovereign wealth fund, CIC. Knowing how to get Chinese investors to open their wallets is a skill both highly rare and highly advantageous in today’s global private equity industry.  

There are two reasons for this stampede to raise renminbi. First, more and more of the best investment opportunities in China are SME with purely domestic structure – meaning they cannot easily raise equity in any other currency except renminbi. The second reason is the most basic of all in the financial industry: if you want money, you go where there’s the most to spare. Right now, that means looking in China.   

In theory, the big international private equity companies have a lot to offer Chinese investors – principally, very long track records of successful deal-making that richly rewarded their earlier investors.

The international PE firms have more experience picking companies and exiting from them with fat gains. They also do a good job, in general, of keeping their investors informed about what they’re doing, and acting as prudent fiduciaries. 

So far so good. But, there’s one enormous problem here, one that Blackstone and others presumably don’t like talking about to prospective Chinese investors. Their main way of making money in the past is now both broken, and wholly unsuited to China. They’re trying to sell a beautiful left-hand drive Rolls-Royce to people who drive on the right. 

Blackstone, Carlyle, KKR, Cerberus and most of the other largest global private equity companies grew large, rich and powerful by buying controlling stakes in companies, using mainly money borrowed from banks. They then would improve the operating performance over several years, and make their real money by either selling the company in an M&A deal or listing it on the stock market.

The leverage (in the form of the bank borrowing) was key to their financial success. Like buying a house, the trick was to put a little money down, borrow the rest, and then pocket most of any increase in the value of the asset. 

It can be a great way to make money, as long as banks are happy to lend. They no longer are. As a result, these kinds of private equity deals – which really ought to be called by their original name of “leveraged buyouts”, have all but vanished from the financial landscape.  It was always a rickety structure, reliant as much on access to cheap bank debt as on a talent for spotting great, undervalued businesses. If proof were needed, just look at Cerberus’s disastrous takeover of Chrysler last year, which will result in likely losses for Cerberus of over $5 billion. 

In his annual letter to shareholders this year, Warren Buffett highlighted the inherent weaknesses in this form of private equity: “A purchase of a business by these [private equity] firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.” 

On their backs at home, it’s no wonder Blackstone, Carlyle, KKR are looking to expand in China, All have a presence in China, having invested in some larger deals involving mainly State-Owned Enterprises. But, to really flourish in China, these PE firms will need to hone a different set of skills: choosing solid companies, investing their own capital for a minority position, and then waiting patiently for an exit. 

There’s no legal way to use the formula that worked so well for so long in the US. In China, highly-leveraged transactions are prohibited. PE firms also, in most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China. 

I have little doubt Blackstone, KKR, Carlyle can all succeed doing these smaller, unleveraged deals in China. After all, they employ some of the smartest people on the planet. But, these firms all still have a serious preference for doing larger deals, investing at least $50mn. This is also true in China.

There are few good deals on this scale around. Very few private companies have the level of annual profits (at least $15mn) to absorb that amount of capital for a minority stake. Private companies that large have likely already had an IPO or are well along in the planning process. As for large SOEs, the good ones are mostly already public, and those that remain are often sick beyond the point of cure. In these cases, private equity investors find it tough to push through an effective restructuring plan because they don’t control a majority on the board seats. 

Result: some of the companies best-positioned to raise renminbi funds, including Blackstone, have an investment model that seems ill-suited to Chinese conditions. They may well succeed in raising money, but then what? They’ll either need to learn to do smaller deals (of $10mn-$20mn) or bear the heavy risk of making investments in the few larger deals around in China.  

Any prospective Chinese LP should be asking Blackstone and the other large global private equity firms some very searching questions about their investment models for China. True, these firms all have excellent track records, by and large. But, that past performance, based on the leveraged buyouts that went well, is of scant consequence in today’s China. What matters most is an eye for spotting great entrepreneurs, in fast-growing industries, and then offering them both capital and the knowledge that comes from building value as investors in earlier deals. 

Prediction: raising huge wads of cash in China will turn out to be easier for Blackstone and other large global PE firms than putting it to work where it will do the most good and earn the highest returns.