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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/

US Private Equity Soars While China Stalls

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In 2014, the gap between the performance of the private equity industry in China and the US opened wide.  The US had a record-breaking year, with ten-year net annualized return hitting 14.6%. Final data is still coming in, but it appears certain US PE raised more capital more quickly and returned more profits to LPs than any year previously.  China, on the other hand, had another so-so year. Exits picked up over 2013, but still remain significantly below highs reached in 2011. As a result profit distributions to LPs and closing of new China-focused funds are also well down on previous highs.

China’s economy, of course, also had an off year, with growth trending down. But, it’s hard to place the blame there. At 7.5%, China’s economy is still growing at around triple the rate of the US. China’s publicly-traded equities market, meanwhile, turned in a stellar performance, with the overall Chinese stock exchange average up 52% in 2014, compared to a 11.4% rise in the US S&P. When stock markets do well, PE firms should also, especially with exits.

While IPO exits for Chinese companies in US, HK and China reached 221, compared to only 66 in 2013, the ultimate measure of success in PE investing is not the number of IPOs. It’s the amount of capital and profits paid back to LP investors. This is China PE’s greatest weakness.

Over the last decade, China PE firms have returned only about 30% of the money invested with them to their LPs. This compares to the US, where PE firms over the same period returned twice the money invested by LPs. In other words, in China, as 2015 commences, PE firm investors are sitting on large cash losses.

China private equity distributions to LPs

 

China PE firms say they hope to return more money to their LPs in the future.  But, this poor pay-out performance is already having an adverse impact on the China PE industry. It is getting harder for most China PE firms to raise new capital. If this trend continues, there will be two negative consequences – first, the China PE industry, now the second largest in the world,  will shrink in size. Second, and more damaging for China’s overall economic competitiveness, the investment capital available for Chinese companies will decline. PE capital has provided over the past decade much-needed fuel for the growth of China’s private sector.

What accounts for this poor performance of China private equity compared to the US? One overlooked reason: China PE has lost the knack of investing and exiting profitably from Chinese industrial and manufacturing companies. Broadly speaking, this sector was the focus of about half the PE deals done up to 2011 when new deals peaked. That mirrors the fact manufacturing accounts for half of China’s GDP and traditionally has achieved high levels (over 30%) of value-added.

Manufacturing has now fallen very far from favor in China. Partly it’s the familiar China macro story of slowing export growth and margin pressures from rising labor costs and other inputs. But, another factor is at work: China’s own stock market, as well as those of the US and Hong Kong, have developed a finicky appetite when it comes to Chinese companies. In the US, only e-commerce and other internet-related companies need apply for an IPO. In Hong Kong, the door is open more widely and the bias against manufacturing companies isn’t quite so pronounced, especially if the company is state-owned. But, among private sector companies, the biggest China-company IPO have been concentrated in financial services, real estate, food production, retail.

For China-investing PE firms, this means in most cases their portfolios are mismatched with what capital markets want. They hold stakes in thousands of Chinese industrial and manufacturing companies representing a total investment of over $20 billion in LP money.  For now, the money is trapped and time is growing short. PE fund life, of course, is finite. Many of these investments were made five to eight years ago. China PE need rather urgently to find a way to turn these investments into cash and return money to LPs. Here too the comparison with US private equity is especially instructive.

The colossus that is today’s US private equity industry, with 3,300 firms invested in 11,000 US companies, was built in part by doing successful buyouts in the 1980s and 1990s of manufacturing and industrial companies, often troubled ones. Deals like Blackstone‘s most successful investment of all time, chemicals company Celanese, together with American Axle and TRW Automotive, KKR‘s Amphenol Corporation, Bain‘s takeover of  Sealy Corporation and many, many others led the way. Meanwhile, smart corporate investors like Warren Buffett’s Berkshire Hathaway, Honeywell, Johnson Controls, Emerson Electric and were also pouring billions into acquiring and shaping up industrial businesses. So successful has this strategy been over the last 30 years, it can seem like there are no decent industrial or manufacturing companies left for US PEs to target.

Along the way, US PEs became experts at selecting, acquiring, fixing up and then exiting from industrial companies. US PEs have shown again and again they are good at rationalizing, consolidating, modernizing and systematizing industrial companies and entire industrial sectors. These are all things China’s manufacturing industry is crying out for. Market shares are fragmented, management systems often non-existent, inventory control and other tools of “lean manufacturing” often nowhere to be found.

So here’s a pathway forward for China PE, to use in China the identical investing skills honed in the US. It should be rather easy, since among the US’s 100 biggest private equity firms, the majority have sizeable operations now in China, including giants like Carlyle, Blackstone, KKR, TPG, Bain Capital, Warburg Pincus. For these firms, it should be no more complicated than the left hand following what the right hand is doing.

It isn’t working out that way. This is a big reason why China PE is performing poorly compared to the US. PE partners in China in the main came into the industry after getting an MBA in the US or UK, then getting a job on Wall Street or a consulting shop. Few have experience working in,  managing or restructuring industrial companies. They often, in my experience, look a little out of place walking a factory floor. This is the other big mismatch in China PE — between the skill-sets of those running the PE firms what’s needed to turn their portfolio companies into winners.

Roll-up, about the most basic and time-tested of all US PE money-making strategies, has yet to take root in China. Inhospitable terrain? No, to the contrary. But, it requires a fair bit of sweat and grit from PE firms.

This may account for the fact that China PE firms are now mainly herding together to try to close deals in e-commerce, healthcare services, mobile games and other places where no metal gets bashed. PE firms formed such a crush to try to invest in Xiaomi, the mobile phone brand, that they drove the valuation up in the latest round of funding to $46 billion, so high none of them decided to invest. China PE is that paradoxical – fewer deals are getting done, fewer have profitable exits and yet valuations are often much higher than anywhere else.

Another worrying sign: of the big successful China company IPOs in 2014 – Alibaba, Dalian Wanda‘s commercial real estate arm, CGN, CITIC Securities, Shaanxi Coal, JD.com, WH Group  – only one had large global PE firms inside as large shareholders. That was WH Group, a troubled deal that had a hard time IPOing and has since sunk rather sharply. For the big global PE firms, 2014 had no big China IPO successes, which is probably a first.

The giant US PEs (Blackstone, Carlyle, KKR, Goldman Sachs Capital Partners, Bain Capital, TPG and the others) all voyaged to China a decade or more ago with high hopes. Some even dared predict China would become as important and profitable a market for them as the US. They were able to raise billions at the start, build big teams, but it’s been getting noticeably harder both to raise money and notch big successful deals. And so their focus is shifting back to the US.

China has so much going for it as an investment destination, such an abundance of what the US lacks. High overall growth, a government rolling in cash, a burgeoning and rapidly prospering middle class, rampant entrepreneurship, huge new markets ripe for taking. Why then are so many of the world’s most professional and successful investors finding it so tough to make a buck here?

 

WH Group Hong Kong IPO Goes Belly Up – Leaving Wall Street’s Most Famed Investment Banks and Some of Asia’s Biggest PE Firms at an Embarrassing Loss

WSJ Shuanghui WH Group failed IPO

There will be an awful lot of embarrassed financial professionals sulking around Hong Kong and Wall Street today. The reason: a crazy IPO deal financially-engineered by a group of 29 big name investment banks, led by Morgan Stanley, together with several large China and Asian-based PE firms including China’s CDH and Singapore’s Temasek Holdings failed to find investors. Their pig’s ear didn’t, as they promised, turn into the silk purse after all. The planned IPO of WH Group has been aborted.

WH Group was created by the banks and PE firms to hold the assets of American pork producer Smithfield Foods bought last year in a leveraged buyout. The other asset inside of WH Group is a majority shareholding in China’s largest pork company Henan Shuanghui Investment & Development.

I was one of the few who actually called into question almost a year ago the logic as well as the economics of the deal. You can read my original article here.

There weren’t a lot of other doubters at the time. The mainstream financial press, by and large, went along with things, accepting at face value the story provided to them by Morgan Stanley, CDH and others. Over the last few months, as the now-failed IPO got into gear in anticipation of closing the deal around now, the press kept up its steady reporting, not raising too many tough questions about what were obviously some glaring weak points – the high debt, the high valuation, the crazy corporate structure that made the deal appear to be what it wasn’t, a Chinese takeover of a big US pork company.

I have no special interest in this deal, since me and my firm never acted for any of the parties involved, nor do I own any shares in any of the companies involved. I just couldn’t get over, in reading the SEC documents filed at the time of the takeover, the brazenness of it, the chutzpah, that these big institutions seemed to be betting they could repackage a pound of sausage bought in New York for $1 as pork fillet and sell it for $5 to Hong Kong investors and institutions.

In other words, saying at the time it looked like the whole thing rested on a very shaky foundation was a reasonable conclusion for anyone who took the time to read the SEC filings. Instead, mainly what we heard about, over and over, was that this was (wrongly) China’s “biggest takeover of a US company,” a “merger between America’s largest pork producer and its counterpart in the world’s largest pork market.”

Morgan Stanley, CDH, Temasek and the others got a little too cocky. The original Smithfield “take private” deal last year went through smoothly. They moved quicker than originally planned to get the company re-listed in Hong Kong. Had they pulled it off, it would have meant huge fees for the investment bankers, and depending on the share price, a juicy return for the PE firms, most of whom had been stuck holding the shares in Henan Shuanghui Investment & Development for over seven years. First came word last week they wanted to cut back by 60% the size of the IPO due to the hostile reception from investors during the road show phase. Then the IPO was suddenly called off late on Tuesday, Hong Kong time.

One of the questions that never got properly answered is why these PE firms didn’t sell their Shuanghui shares on the Chinese stock market, but held them since IPO, without exiting. That’s unusual, especially since Shuanghui’s shares have traded well above the level CDH and others bought in at. I wasn’t in China at the time, but that original investment did not cover itself in praise and glory. Almost immediately after the PE firms went in, providing the capital to allow the state-owned Shuanghui to privatize itself in 2006, the rumors began to circulate that the deal was deeply corrupt, and for reasons never explained, was structured in a way where the PE firms did not have a way to exit through normal stock market channels.

The Smithfield acquisition never made much of any industrial sense. The PE firms that now own the majority (mainly CDH, Temasek, New Horizon, but also including Goldman Sachs’ Asia PE arm ) have no experience or knowledge how to run a pork business in the US. In fact, they don’t know how to run any business in the US. The Shuanghui China management, which is meant now to be serving two separate masters, simultaneously running the Chinese company and its troubled American cousin, similarly don’t know a hock from a snout when it comes to raising and selling pork in the US. This is, was and will remain the main business of Smithfield. Not exporting pork to China. How, when and why these US assets can be listed in Asia must certainly now count as a mystery to all of the big-name financial institutions involved, including Bank of China, which lent billions to finance the takeover last year, as did Morgan Stanley itself.

So, now we have this sorry spectacle of the PE firms, together with partners, having seemingly thrown more money away in a failed bid to rescue the original Shuanghui investment from its unexplained illiquidity. The WH Group IPO failure is also a stunning rebuke for the other PE-backed P2P take private deals now waiting to relist in Hong Kong. (Read here, here, here.) Smithfield, while no great shakes, is the jewel among the rather sorry group of mainly-Chinese companies taken private from the US stock exchange with the plan to sell them later to Hong Kong-based investors via an IPO.

This was among the most bloated IPOs ever, with 29 investment banks given underwriting mandates to sell shares. ( The IPO banks included not only Morgan Stanley, but also Citic Securities, Goldman Sachs, UBS, Barclays, Credit Suisse, JP Morgan, Nomura, Citigroup, Deutsche Bank.) All that expensive investment banking firepower. Result: among the most expensive IPO duds in history.

For the PE consortium that owns WH Group, they will have already likely lost over USD$15mn in LP money on legal, underwriting and accounting fees on this failed IPO. This is on top of a whopping $729mn fees paid by the PE firms for what are called “one-off fees and share-based payments” to acquire Smithfield. The subsequent restructuring ahead of IPO? Maybe another $100mn. If or when the WH Group IPO is tried again, the fees will likely be at least as high as the first time around. In short, the PE firms are already close to $1 billion in the red on this deal, not including interest payments on all the debt.  Smithfield itself remains lacklustre. Its net profit shrank 50% during the fiscal year leading up to the buyout.

With no IPO proceeds anywhere on the horizon, the issue looming largest now for the PE firms: is WH Group generating enough free cash to service the $7 billion in debt, including $4 billion borrowed to buy sputtering Smithfield? If not, next stop is Chapter 11.

By contrast, now feeling as delighted as pigs in muck are the mainly-US shareholders who last year sold their Smithfield shares at a 31% premium above the pre-bid price to the Chinese-led PE group. It doesn’t offset by much the US trade deficit with China, which reached a new record last year of $318 billion. But these US investors also get the satisfaction of knowing they have so far received the far better end of a deal against some of the bigger, richer financial institutions in Asia and Wall Street.

 

Pork chopped. Why did hog giant WH Group’s IPO fail to entice investors? — Week in China

week in china

Week in China cover

Pork chopped

Why did hog giant’s IPO fail to entice investors?

During the world’s biggest probate dispute a few years ago, a fascinated audience learned that Nina Wang, the late chairwoman of Hong Kong real estate developer Chinachem, paid $270 million to her feng shui adviser (and lover) to dig lucky holes. As many as 80 of them were dug around Wang’s properties to improve her fortune.

One of these holes – about three metres wide and nine metres deep, according to the China Entrepreneur magazine – was burrowed outside a meat processing plant in China.

Why so? Chinachem was the first foreign investor brought in by Shuanghui bosses in 1994 to help the abattoir expand. Wang’s capital would jumpstart the firm’s extraordinary transformation from a state-owned factory in Henan’s Luohe city into China’s biggest (and privately-held) pork producer.

Seeing Shuanghui’s potential, Wang offered to acquire its trademark and then to buy a majority stake for HK$300 million ($38 million). Both proposals were rejected outright by Shuanghui’s chairman Wan Long (see WiC201 for a profile of the man known locally as the ‘Steve Jobs of Chinese butchery’). His rationale was that he wanted to “make full use of foreign capital, but not be controlled by it”. Despite never owning a majority stake in the hog firm, he insisted on running the company his own way.

Two decades have passed since Wan first courted Nina Wang’s cash and in that time a range of new investors have bought into the company. Last year they helped Shuanghui to acquire American hog producer Smithfield for $7.1 billion (including debt) and in January the firm was renamed WH Group, ahead of a multi-billion dollar Hong Kong listing. But embarrassingly the IPO was pulled this week, as plans for the flotation went belly-up.

Not bringing home the bacon…

When WH applied to list on Hong Kong’s stock exchange in January, the firm talked up the prospect of launching the city’s biggest IPO since 2010. It kicked off the investor roadshow early last month intending to raise up to $5.3 billion. Four fifths of the total was to be used to help WH repay loans taken to finance the Smithfield takeover, with bankers setting the price between HK$8 and HK$11.25 a share. This was “an unusually wide indicative range” according to Reuters, but also a recognition of the uncertain outlook in the Hong Kong stockmarket.

A few weeks later, the 29 banks hired to promote the IPO (a record) returned with lukewarm orders. WH was forced to cleave the offer by more than half. Excluding the greenshoe allotment, the new plan was dramatically less ambitious, and looked to raise between $1.34 billion and $1.88 billion. To boost investor confidence, existing owners also dropped plans to sell some of their own shares in the listing. WH’s trading debut was pushed back by a week to May 8.

But investors remained unenthused. Blaming “deteriorating market conditions and recent excessive market volatility” (the prefferred explanation for most failed IPOs), WH shelved its IPO on Tuesday.

“The world’s largest pork company has gone from Easter ham to meagre spare rib,” the Wall Street Journal quipped.

Were rough market conditions to blame?

The failed deal was another blow for bankers in Hong Kong’s equity capital markets, who have watched the planned IPO of Hutchison’s giant retail arm AS Watson slip away and have seen Alibaba Group opt to go to market in New York instead.

Volatile markets may have contributed to WH’s decision to postpone the listing. Hong Kong’s Hang Seng index dropped 4.5% between the deal’s formal launch on April 10 and its eventual withdrawal on April 29, according to the South China Morning Post. Other IPOs haven’t been faring well recently. Japanese hotel operator Seibu Holdings and Chinese internet firm Sina Weibo both pared back share sales last month, while the Financial Times notes that concerns about China’s slowing economy have depressed interest in Chinese assets more generally.

Nevertheless, investors were anxious about WH’s investment story too and specifically whether the company’s valuation was too high.

One of the selling points of the original Shuanghui takeover of Smithfield was that it married a reputable American brand with a company that wanted to adapt best practices in product quality and food safety in China. But if one longer term goal was to improve the reputation of Chinese pork – and boost confidence among the country’s jaded consumers – the more immediate business logic was to sell Smithfield’s lower-cost meat into China, where prices at the premium end of the market are typically higher.

“We plan to leverage our US brands, raw materials and technology, our distribution and marketing capabilities in China and our combined strength in research and development to expand our range of American-style premium packaged meats products offerings in China,” the company said in its prospectus. “We expect [this] to positively affect our turnover and profitability.”

In recent months this strategy has faced headwinds, with prices going – from the pork giant’s perspective – in the wrong direction. American pig farmers are struggling with a porcine virus that has wiped out more than 10% of hog stocks. This has sent US pork to new highs, meaning it’s no longer so low-cost. In contrast, Xinhua notes that pork prices in many Chinese cities have fallen to their lowest levels in five years. As such, the commercial case for exporting US pork to China isn’t as strong. So fund managers have needed more convincing of the value of the newly combined Shuanghui and Smithfield businesses.

So WH’s valuation was too high?

Bloomberg said WH was prepared to sell its shares towards the bottom of the marketed price range, which equates to a valuation of 15 times estimated 2014 earnings.

At first glance that doesn’t look too demanding. Henan Shuanghui Investment, the Chinese unit of WH Group that is listed in Shenzhen, carries a market capitalisation of Rmb78 billion ($12.6 billion), or 20 times its 2013 net profit. Hormel, a Minnesota-based food firm that produces Spam luncheon meat (and is a key competitor for WH’s American pork business) trades at a price-to-earnings ratio of 23.

Hence China Business Journal concludes that WH priced itself as “not too high and not too low” among peers, especially if the company can generate genuine synergies between its China operation and its newly acquired American unit.

But an alternate view is that these synergies aren’t immediately obvious and that the new business model has hardly been tested (the Smithfield deal closed last September and exports to China didn’t start until the beginning of this year). The criticism is that WH hasn’t done much more than put Shuanghui Investment and Smithfield together into a holding vehicle, but is now asking for a valuation greater than the sum of the two parts. “Even at the bottom of the range, the IPO implies a valuation for Smithfield 21% above the price WH Group paid for the US pork producer barely eight months ago,” notes Reuters Breakingviews. (And let’s not forget, Smithfield was purchased at a 30% premium to its market price at the time.)

Or as one banker put it to the FT: “It’s like buying a house, ripping out the bathrooms and kitchen and trying to flip it for a premium six months later.”

CBN agreed that investors have the right to be wary: “The market simply has not had time to judge if there is meaningful synergy coming out of WH’s units. Nor is there a single signal that WH has the ability to properly manage an American firm.”

Why did WH want to IPO so fast?

This question brings us back to Shuanghui’s transformation from a state-owned enterprise to a privately-held firm. In April 2006 a consortium including Goldman Sachs and Chinese private equity funds CDH and New Horizon paid about $250 million to buy out the city government’s stake in Shuanghui.

The leveraged buyout was an unusual example of a Chinese national brand (and market leader) being snapped up by foreign buyers. Shuanghui was stripped of its SOE status, with majority ownership passing to private and foreign investors.

Century Weekly suggested last month that most of these Shuanghui shareholders “have waited patiently for at least eight years to exit”. Perhaps running low on their reserves of restraint, they then introduced the Smithfield bid last year to great fanfare as the largest takeover yet of a US company by a Chinese firm.

But as Peter Fuhrman, chairman of China First Capital, a boutique investment bank, told WiC at the time, this wasn’t really the case. In fact the bid for Smithfield was a leveraged buyout by a company based in the Cayman Islands, not a Chinese one. And its main purpose was to facilitate a future sale by Shuanghui’s longstanding investors.

How so? WH’s set-up is complex: the IPO prospectus features an ownership chart containing WH Group, Shuanghui Group and Shuanghui Investment (not to mention several dozen joint ventures and Smithfield itself). One of these entities is listed in Shenzhen, but the investor group has been looking for other ways to cash out. A key motivation in last year’s dealmaking was that they thought they had found an alternative route via a Hong Kong IPO.

And less than a year after the Smithfield bid, WH made its move, not least because it needs to reduce some of the debt incurred in buying its new American business.

But many market watchers think it looked too hasty. “They rushed into an IPO and didn’t spend time to actually create the synergy between the US and Chinese business,” one fund manager in Hong Kong complained to FinanceAsia this week. “They wanted to float the stock to fund the acquisition and also let the private equity firms exit. But if WH Group is good, then ride with me. Why should I buy when you are selling?”

Fuhrman’s view is much more withering: “I just couldn’t get over, in reading the SEC documents at the time of the takeover, the brazenness of it, the chutzpah, that these big institutions seemed to be betting they could repackage a pound of sausages bought in New York for $1 as pork fillet and sell it for $5 to investors in Hong Kong.”

And what of the boss? Wan Long and another director Yang Zhijun pocketed almost $600 million in share options between them last year after the Smithfield bid went through. (The move pushed WH into a loss in 2013.) The size of the compensation package is said to have also deterred some fund managers.

What next for WH?

Any attempt to resurrect the offering will have to wait until after its first-half results, meaning a possible return to the market in September at the earliest. There have been reports that the deal is more likely be postponed until next year. CDH, the company’s single largest shareholder, told the Wall Street Journal that it refuses to sell its WH shares cheaply. “We have a strong belief in the business’ fundamentals and its long term value,” a spokesperson insisted.

But China Business Journal says that WH now needs to focus on convincing investors that it has a good story to tell, including providing a clearer integration plan for Smithfield and Shuanghui’s operations. The pressure will also increase to find alternative ways to retire some of the debt taken on to finance the Smithfield acquisition. Reports suggest that early refinancing was expected to reduce debt repayments by around $155 million on an annualised basis – or about 5% of last year’s profit.

WH may also use the delay to rethink how it goes to market next time, with the South China Morning Post reporting that senior executives have been blaming the banks for the breakdown. “Some of them were too confident, and even a bit arrogant, when they tried to price the deal and coordinate with each other,” the source told the newspaper.

Then again, the banks will be irked by the expenses inccurred on a deal that didn’t happen. And in retrospect it looks to have been a flawed decision to mandate 29 of them. As WH has learned, it diffused responsibility and may have disincentivised some of the participants.

Indeed, another comment on the situation is that the only winners from this IPO were the airlines and hotels that were used as part of the roadshow process.

http://www.weekinchina.com/2014/05/pork-chopped/?dm

 

WH’s canceled IPO shows dangers of misjudging demand — China Daily Article

China Daily

WH’s canceled IPO shows dangers of misjudging demand

By Michael Barris (China Daily USA)

It could have been the largest IPO in a year. Instead the canceled initial offering of Chinese pork producer WH Group became an epic flop and an example of the pitfalls of failing to accurately gauge investor demand for IPOs.

Eight months ago, in the biggest-ever Chinese acquisition of a US company, WH, then known as Shuanghui International Holdings Ltd, acquired Virginia-based Smithfield Foods Inc, the world’s largest hog producer, for $4.7 billion. Awash in kudos for tapping into China’s increasing demand for high-quality pork, a Shuanghui team began working on a planned Hong Kong IPO.

By late April, however, the proposed offering was in deep trouble. Bankers slashed the deal’s marketed value to $1.9 billion from $5.3 billion. Finally, the company, now renamed WH Group, announced it would not proceed with the IPO because of “deteriorating market conditions and recent excessive market volatility”.

The decision handed the company a setback in its effort to cut the more than $2.3 billion of debt it took on in the Smithfield purchase and dealt a blow to Asia’s already struggling IPO market and the stock prices of some formerly high-flying Asian companies. The WH IPO debacle is even seen as possibly hampering the much-anticipated New York IPO of Chinese e-commerce giant Alibaba Group, expected to occur later this year and valued at an estimated $20 billion.

WH's canceled IPO shows dangers of misjudging demand

What went wrong? To put it simply, investors scoffed at the idea of paying top price for WH shares without any clear indication of how the Smithfield acquisition would save money.

The price range of HK$ 8 to HK$ 11.25 per share ($1.03 to $1.45) was at a valuation of 15 to 20.8 times forward earnings. “The synergies between Shuanghui and Smithfield are untested. Why do investors have to buy in a hurry?” Ben Kwong, associate director of Taiwanese brokerage KGI Asia Ltd, was quoted in the Wall Street Journal. “They would rather wait until the valuation is attractive.”

A disease that infected pigs, inflating US prices, also turned off investors. US pork typically trades at about half the meat’s price in China, because US feed tends to be cheaper. But Chicago hog futures have soared 47 percent this year to $1.25 a pound. Investors also saw corporate governance practices which awarded shares to two executives before the listing occurred as worrisome.

“I just couldn’t get over, in reading the SEC documents filed at the time of the takeover, the brazenness of it,” China First Capital CEO and Chairman Peter Fuhrman wrote on the Seeking Alpha investment website. “These big institutions seemed to be betting they could repackage a pound of sausage bought in New York for $1 as pork fillet and sell it for $5 to Hong Kong investors and institutions.

The Smithfield acquisition “never made much of any industrial sense”, Fuhrman wrote. The private equity firms behind WH – CDH Investments, Singapore state investor Temasek Holdings and New Horizon – “have no experience or knowledge how to run a pork business in the US. In fact, they don’t know how to run any business in the US”, he wrote.

One man’s meat, however, is another man’s poison. As Fuhrman wrote, the debacle has ended up putting smiles on the faces of the mainly-US shareholders who last year reluctantly sold their Smithfield shares at a 31 percent premium above the pre-bid price. Some of these same shareholders had protested that the Chinese company’s offer for the pork producer was too low. Ultimately, the sellers received the satisfaction of knowing they got the “far better end of a deal against some of the bigger, richer financial institutions in Asia and Wall Street,” Fuhrman wrote. And that, he said, has likely made them as delighted as pigs in muck.

 

http://usa.chinadaily.com.cn/2014-05/14/content_17508033.htm

Smithfield Foods – Shuanghui International: The Biggest Chinese Acquisition That Isn’t


It is, if voluminous press reports are to be believed, the biggest story, the biggest deal, ever in China-US business history. I’m talking about the announced takeover of America’s largest pork company, Smithfield Foods, by a company called Shuanghui International. The deal, it is said in dozens of media reports, opens the China market to US pork and will transform China’s largest pork producer into a global giant selling Smithfield’s products alongside its own in China, while utilizing the American company’s more advanced methods for pork rearing and slaughtering.

One problem. A Chinese company isn’t buying Smithfield. A shell company based in Cayman Islands is. Instead of a story about “China buying up the world”, this turns out to be a story of a precarious leveraged buyout deal (“LBO”) cooked up by some large global private equity firms looking to borrow their way to a fortune.

The media, along with misstating the facts, are also missing the larger story here. The proposed Smithfield takeover is the latest iteration in the “take private” mania now seizing so many of the PE firms active in China. (See blog posts hereherehere and here.) With China’s own capital markets in crisis and PE investment there at a standstill, the PE firms have turned their attention, however illogically, to finding “undervalued assets” with a China angle on the US stock market. They then attempt an LBO, with the consent of existing management, and with the questionable premise the company will relist or be sold later in China or Hong Kong. The Smithfield deal is the biggest — and perhaps also the riskiest —  one so far.

This shell that is buying Smithfield has no legal or operational connection to Henan Shuanghui Investment & Development (from here on, “Shuanghui China”) , the Chinese pork producer, China’s largest, quoted on the Shenzhen stock exchange. The shell is about as Chinese as I am.

If the deal is completed, Shuanghui China will see no obvious benefit, only an enormous risk. Its Chinese assets are reportedly being used as collateral for the shell company to finance a very highly-leveraged acquisition. The abundant risks are being transferred to Shuanghui China while all the profits will stay inside this separately-owned offshore shell. No profits or assets of Smithfield will flow through to Shuanghui China. Do Shuanghui China’s Chinese minority shareholders know what’s going on here? Does the world’s business media?

Let’s go through this deal. I warn you. It’s a little convoluted. But, do take the time to follow what’s going on here. It’s fascinating, ingenious and maybe also a little nefarious.

First, the buyer of Smithfield is Shuanghui International, a Cayman holding company. It owns the majority of Shuanghui China, the Chinese-quoted pork company. Shuanghui International is owned by a group led by China-focused global PE firm CDH, with smaller stakes owned by Shuanghui China’s senior management,  Goldman Sachs, Singapore’s Temasek Holdings, Kerry Group, and another powerful PE firm focused on China, New Horizon Fund.

CDH, the largest single owner of Shuanghui International,  is definitively not Chinese. It invests capital from groups like Abu Dhabi’s sovereign wealth fund , CALPERS, the Rockefeller Foundation, one big Swiss (Partners Group) and one big Liechtenstein (LGT) money manager, along with the private foundation of one of guys who made billions from working at eBay. So too Goldman Sachs, of course, Temasek and New Horizon. They are large PE firms that source most of their capital from institutions, pension fund and endowments in the US, Europe, Southeast Asia and Middle East. (For partial list of CDH and New Horizon Fund Limited Partners click here. )

For the Smithfield acquisition, Shuanghui International (CDH and the others) seem to be putting up about $100mn in new equity. They will also borrow a staggering $4 billion from Bank of China’s international arm to buy out all of Smithfield’s current shareholders.  All the money is in dollars, not Renminbi.

If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But, nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part-owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.

Shuanghui International, assuming it’s borrowed the money from Bank of China for three years,  will need to come up with about $1.5 billion in interest and principal payments a year if the deal closes. But, since Shuanghui International has no significant cash flow of its own (it’s an investment holding company), it’s hard to see where that money will come from. Smithfield can’t be much help. It already has a substantial amount of debt on its balance sheet. As part of the takeover plan, the Smithfield debt is being assumed by Morgan Stanley, Shuanghui International’s investment bankers. Morgan Stanley says it plans then to securitize the debt. A large chunk of Smithfield’s future free cash flow ($280mn last year) and cash ($139 mn as of the first quarter of 2013) will likely go to repay the $3 billion in Smithfield debts owed to Morgan Stanley.

A separate issue is whether, under any circumstances, more US pork will be allowed into China. The pork market is very heavily controlled and regulated. There is no likely scenario where US pork comes flooding into China. Yes, the media is right to say Chinese are getting richer and so want to eat more meat, most of all pork. But, mainly, the domestic market in China is reserved for Chinese hog-breeders. It’s an iron staple of China’s rural economy. These peasants are not going to be thrown under the bus so Smithfield’s new Cayman Islands owner can sell Shuanghui China lots of Armour bacon.

Total borrowing for this deal is around $7 billion, double Smithfield’s current market cap. Shuanghui International’s piece, the $4 billion borrowed from Bank of China, will go to current Smithfield shareholders to buy them out at a 31% premium.  Shuanghui International owns shares in Shuanghui China, and two of its board members are Shuanghui China top executives, but not much else. So where will the money come from to pay off the Bank of China loans? Good question.

Can Shuanghui International commandeer Shuanghui China’s profits to repay the debt? In theory, perhaps. But,  it’s highly unlikely such an arrangement would be approved by China’s securities regulator, the CSRC. It would not likely accept a plan where Shuanghui China’s profits would be exported to pay off debts owed by a completely independent non-Chinese company. Shuanghui International could sell its shares in Shuanghui China to pay back the debt. But, doing so would likely mean Shuanghui International loses majority control, as well as flooding the Shenzhen stock market with a lot of Shuanghui China’s thinly-traded shares.

Why, you ask, doesn’t Shuanghui China buy Smithfield? Such a deal would make more obvious commercial and financial sense. Shuanghui China’s market cap is triple Smithfield’s. Problem is, as a domestic Chinese company listed on China’s stock exchange, Shuanghui China would need to run the gauntlet of CSRC, Ministry of Commerce and SAFE approvals. That would possibly take years and run a risk of being turned down.  Shuanghui International, as a private Caymans company controlled by global PE firms,  requires no Chinese approvals to take over a US pork company.

The US media is fixated on whether the proposed deal will get the US government’s go ahead. But, as the new potential owner is not Chinese after all — neither its headquarters nor its ownership — then on what grounds could the US government object? The only thing Chinese-controlled about Shuanghui International is that the members of the Board of Directors were all likely born in China. The current deal may perhaps violate business logic but it doesn’t violate US national security.

So, how will things look if Shuanghui International’s LBO offer is successful?  Shuanghui China will still be a purely-Chinese pork producer with zero ownership in Smithfield, but with its assets perhaps pledged to secure the takeover debts of its majority shareholder. All the stuff about Shuanghui China getting access to Smithfield pork or pig-rearing and slaughtering technology, as well as a Smithfield-led upgrade of China’s pork industry,  is based on nothing solid. The pork and the technology will be owned by Shuanghui China’s non-Chinese majority shareholder. It can, if it chooses, sell pork or technology to Shuanghui China. But, Shuanghui China can achieve the same thing now. In fact, it is already a reasonably big buyer of Smithfield pork. Overall, China gets less than 1% of its pork from the US.

If the deal goes through, the conflicts of interest between Shuanghui International and Shuanghui China will be among the most fiendish I’ve ever seen. Shuanghui China’s senior managers, including chairman Wan Long, are going to own personally a piece of Smithfield, and so will have divided loyalties. They will likely continue to manage Shuanghui China and collect salaries there, while also having an ownership and perhaps a management role in Smithfield. How will they set prices between the two fully separate Shuanghuis? Who will watch all this? Isn’t this a case Shuanghui China’s insiders lining their own pockets while their employer gets nothing?

On its face, this Smithfield deal looks to be among the riskiest of all the  “take private” deals now underway. That is saying something since several of them involve Chinese companies suspected of accounting frauds, while the PE firms in at least two cases (China Transinfo and Le Gaga) doing the PE version of a Ponzi Scheme by seeking to use new LP money to bail out old, severely troubled deals they’ve done.

Let’s then look at the endgame, if the Smithfield deal goes through. Shuanghui International, as currently structured,  will not, cannot, be the long-term owner of Smithfield. The PE firms will need to exit. CDH, New Horizon, Goldman Sachs and Temasek have been an indirect shareholders of Shuanghui China for many years — seven in the case of CDH and Goldman.

According to what I’m told, Shuanghui International is planning to relist Smithfield in Hong Kong in “two to three years”. The other option on the table, for Shuanghui International to sell Smithfield (presumably at a mark-up) to Shuanghui China, would face enormous, probably insurmountable,  legal, financial and regulatory hurdles.

The IPO plan, as of now, looks crackpot. Hong Kong’s IPO market has basically been moribund for over a year. IPO valuations in Hong Kong are anyway far lower than the 20X p/e Shuanghui International is paying for Smithfield in the US. A separate tactical question for Shuanghui International and its investment bankers: why would you believe Hong Kong stock market investors in two to three years will pay more than US investors are now paying for a US company, with most of its assets, profits and revenues in the US?

But, even getting to IPO will require Shuanghui International to do something constructive about paying off the enormous $4 billion in debt it is taking on. How will that happen? Shuanghui International is saying Smithfield’s current American management will stay on. Why would one assume they can run it far more profitably in the future than they are running it now? If it all hinges on “encouraging” Shuanghui China to buy more Smithfield products, or pay big licensing fees, so Shuanghui International can earn larger profits, I do wonder how that will be perceived by both Shuanghui China’s minority investors, to say nothing of the CSRC. The CSRC has a deep institutional dislike of related party transactions.

Smithfield has lately been under pressure from some of its shareholders to improve its performance. That may have precipitated the discussions that led to the merger announcement with Shuanghui International. Smithfield’s CEO, C. Larry Pope, stands to earn somewhere between $17mn-$32mn if the deal goes through. He will stay on as CEO. His fiscal 2012 salary, including share and option awards, was $12.9mn.

Typical of such LBO deals, the equity holders (in this case, CDH, Goldman, Temasek, Kerry Group, Shuanghui China senior management, New Horizon) would stand to make a killing, if they can pay down the debt and then find a way to either sell or relist Smithfield at a mark-up. If that happens, profits will go to the Shuanghui insiders along with the partners in the PE firms, CALPERS, the Rockefeller and Carnegie foundations, Goldman Sachs shareholders and other LPs. Shuanghui China? Nothing, as far as I can tell. China’s pork business will look pretty much exactly as it does today.

In their zeal to proclaim a trend — that of Chinese buying US companies — the media seems to have been blinded to the actual mechanics of this deal. They also seem to have been hoodwinked by the artfully-written press release issued when the deal was announced. It mentions that Shuanghui International is the ” majority shareholder of Henan Shuanghui Investment & Development Co. (SZSE: 000895), which is China’s largest meat processing enterprise and China’s largest publicly traded meat products company as measured by market capitalization.” This then morphed into a story about “China’s biggest ever US takeover”, and much else besides about how China’s pork industry will now be upgraded through this deal, about dead pigs floating in the river in Shanghai, about Chinese companies’ targeting US and European brands.

China may indeed one day become a big buyer of US companies. But, that isn’t what’s happening here. Instead, the world’s leading English-language business media are suffering a collective hallucination.

Smithfield & Shuanghui: One little piggy comes to market — Week In China

week in china

A record bid for America’s top pork producer isn’t quite as it first appears

“What I do is kill pigs and sell meat,” Wan Long, chairman at Henan Shuanghui Development, told Century Weekly last year.

It’s an admirably succinct job description for a man who has been lauded by China National Radio as the “Steve Jobs of Chinese butchery” (Jobs, a vegan, probably wouldn’t have approved).

Starting out with a single processing factory in Luohe in Henan province, Shuanghui is now the largest meat producer in China, having benefitted in recent years from a shift in the Chinese diet away from rice and vegetables towards more protein.

So the announcement that it is now making a bid for the world’s largest hog producer, Smithfield Foods from Virginia in the US, prompted a flurry of headlines about the significance of the deal; its chances of getting security clearance from the Committee on Foreign Investment in the United States (CFIUS); and the broader implications for the meat trade in both countries if the takeover goes through.

Yet although Wan makes his profession sound like a simple one, Shuanghui’s bid for Smithfield turns out to be rather more complicated than many first assumed. Far from a case of a Chinese firm swooping in on an American target, the takeover reflects more complex trends too, including some of the peculiarities of the Chinese capital markets.

What first made headlines on the deal?

Privately-owned Shuanghui International has bid $7.1 billion for Smithfield Foods (including taking on its debt) in what the media is widely presenting as the biggest acquisition yet by a Chinese company of a US firm.

Shuanghui has processing plants in 13 provinces in China and produces more than 2.7 million tonnes of meat each year. But the plan is now to add Smithfield’s resources to the mix. “The acquisition provides Smithfield the opportunity to expand its offering of products to China through Shuanghui’s distribution network,” Wan announced. “Shuanghui will gain access to high-quality, competitively-priced and safe US products, as well as Smithfield’s best practices and operational expertise.”

What’s behind the move?

Most analysts have chosen to focus on Shuanghui’s desire to secure a more consistent supply of meat. Currently, it raises 400,000 of its own hogs a year, only a small share of the 11 million that it needs. That makes it reliant on other breeders in a country where the latest scare about contaminated meat is never far from the headlines. In the most recent case in March, the carcasses of thousands of pigs suddenly started floating down the Huangpu river upstream of Shanghai, after an outbreak of disease in nearby farms and a clampdown on the illicit sale of infected meat (see WiC186).

Now Shuanghui is said to be looking further afield to secure meat, and from a source that would allow it to differentiate its product range from that of its competitors.

“They’re a major processor who wants to source consistent, large volumes of raw material. You want to look at the cheapest sources and in the US, we’re very competitive,” Joel Haggard from the US Meat Export Federation told Bloomberg. Average hog prices in China are currently about $2.08 per kilo or a third higher than in the United States, Haggard also suggested.

How about changes in the industry in China?

A second theory is that Shuanghui is developing a more integrated supply chain in China and wants Smithfield’s help to complete the process.

This was something that C Larry Pope, chief executive at Smithfield, cited as a key factor in its willingness to pay a 31% premium for Smithfield stock. If so, that’s something of an irony: Continental Grain, Smithfield’s largest investor, has been pushing for a break up of the business to unlock more value for investors.

Still, an argument can be made that industry conditions are different in China, where the supply chain is shifting away from its reliance on more traditional household farming (the Mandarin character for “home” depicts a pig under a roof, for instance) to one in which large-scale, industrialised production begins to dominate.

Food safety concerns and the need to improve quality standards are also driving change across the industry. Yet despite signs of consolidation in hog breeding and slaughtering, integration across the full supply chain is a challenge. Shuanghui has already been trying to develop more of its own cold chain rather than rely on third parties (it operates seven private railways to transport its goods to 15 logistics centres, for instance, and has also invested in hundreds of its own retail outlets). But the Smithfield acquisition could help further with the integration effort, especially in areas such as adopting technology that tracks meat from farm to fork.

Paul Mariani, a director at agribusiness firm Variant Capital Advisors, told the Wall Street Journal last week that these systems have huge food safety benefits, allowing producers to track meat back to “where it was grown”. By contrast, Chinese suppliers struggle to achieve the same level of control, especially for meat sourced from the large number of smaller, family-owned firms.

How about in the US? Are Americans pleased with the deal?

The bid has already been referred to CFIUS, the committee that reviews the national security implications of foreign investments in US firms. But Smithfield’s Pope sounds confident, saying that he doesn’t expect “any concern” from the regulatory committee.

“We’re not exporting tanks and guns and cyber security,” he told reporters. “These are pork chops.”

All the same, the regulators will look at Smithfield’s supply contracts with the military, as well as whether any of its farms and factories are close to sensitive locations, an issue that has led to transactions being blocked or amended in the past.

For instance, the Obama administration intervened in the purchase of four Oregon wind farms by a Chinese acquirer this year because they were too close to a naval base.

“There’s a difference between a foreign company buying Boeing and one buying a hot dog stand,” Jonathan Gafni, president of Compass Point Analytics, which specialises in security reviews of this type, told the New York Times. “But it depends on which corner the stand is on.”

The committee will also look at whether Shuanghui could be in a position to disrupt the distribution of pork to American consumers. Indeed, Charles Grassley, the Republican Senator of Iowa, has already urged regulators to look closely at whether the Chinese government has any influence on Shuanghui’s management.

More ominously on Wednesday the chairwoman of the Senate’s Agriculture Committee expressed her concerns. Debbie Stabenow said those federal agencies considering the merger must take into account “China’s and Shuanghui’s troubling track record in food safety”. She further added that those agencies must “do everything in their power to ensure our national security and the health of our families is not jeopardised”.

Despite such concerns, the food security argument looks limited in scope, although some of the Chinese newspapers don’t expect the review to pass without issue. “Even the conspicuous absence of national security factors can hardly guarantee that US protectionists will not poke their noses into it,” the China Daily suggested pointedly.

Back in Washington, Elizabeth Holmes, a lawyer working for the Center for Food Safety, has also called for regulators to consider the bid from the wider perspective of food safety. “They’re supposed to identify and address any national security concerns that would arise,” she warned. “I can’t imagine how something like public health or environmental pollution couldn’t be potentially construed as a national security concern.”

The implication is that the takeover might damage Smithfield’s operations in the United States in some way, even leading to contamination among its locally sold products. Hence the fact that Shuanghui was forced to recall meat tainted by the additive clenbuterol two years ago has been seized upon by the deal’s critics.

Again, the Chinese media response has tended to be indignant, with widespread reference to Smithfield’s own use of ractopamine, an additive similar to clenbuterol that’s banned in hog rearing in China but not by authorities in the US.

According to Reuters, Smithfield has been trying to phase out its usage of the drug, presumably to clear the way for an increase in sales to China. And in response to American anxiety about food safety post-takeover at Smithfield, both parties have gone out of their way to reiterate that the goal is to export more American pork to the Chinese, and not vice versa. Smithfield’s chief executive Pope has argued the case directly, citing the superiority of American meat. “People have this belief…that everything in America is made in China,” he told reporters. “Open your refrigerator door, look inside. Nothing in there is made in China because American agriculture is the most competitive and efficient in the world.”

Similarly, Shuanghui executives are insisting that nothing will change in how Smithfield serves up its sausages to American customers. The company will continue to be run on a standalone basis under its current management team, no facilities will be closed, no staff will be made redundant and no contracts will be renegotiated. Food safety standards will remain as today. “We want the business to stay the same, but better,” Wan said.

So it sounds like the Smithfield deal could turn out to be a major coup for the Chinese buyer?

Not really, says Peter Fuhrman, chairman of China First Capital, a boutique investment bank and advisory firm based in Shenzhen. He thinks that much of the analysis of the bid for Smithfield has completely missed the point. That’s because Shuanghui International – the entity making the offer – is a shell company based in the Cayman Islands. It isn’t a Chinese firm at all, he says.

Shuanghui International also has majority control of Shuanghui Development, the Shenzhen-listed firm that runs the domestic meat business in China. But it is controlled itself by a group of investors led by the private equity firm CDH (based in China but heavily backed by Western money) and also featuring Goldman Sachs, Temasek Holdings from Singapore and Kerry Group.

The management at Shuanghui, led by Wan, holds a small stake in the new, offshore entity. But as far as Fuhrman is concerned, Shuanghui International has no legal or operational connection to Shuanghui’s domestic operations.

“If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.”

Of course, this raises questions about how the bid for Smithfield is being debated, especially its portrayal as the biggest takeover of a US firm by a Chinese one to date. It prompts queries too about the national security review underway in Washington, particularly any focus on the supposedly Chinese identity of the bidder. As it turns out, the Shuanghui bidding vehicle simply isn’t constituted in the way that people like Senators Grassley and Stabenow seem to believe.

So what is going on? Fuhrman says the bid for Smithfield is actually a leveraged buyout, made during a period in which private equity firms have been prevented from exiting their investments in China by blockages in the IPO pipeline (see WiC176 for a fuller discussion on this).

Instead, the investors that own Shuanghui are borrowing billions of dollars from the Bank of China and others to fund their purchase, with Fuhrman noting speculation that the plan is to relist Smithfield at a premium in Hong Kong in two or three years time.

How Shuanghui International is going to meet the interest payments on its borrowings in the meantime is less clear. But one possibility is that it will lean on Shuanghui Development, the operator in the Chinese market, to share some of the financial load. That could be problematic, raising hackles at the China Securities Regulatory Commission. It also prompts questions about the potential conflicts of interest (“among the most fiendish I’ve ever seen,” says Fuhrman) in the relationship between the investors that own Smithfield and the fuller group of shareholders at Shuanghai in China.

Ma Guangyuan, an economics blogger with more than half a million readers, takes a similar view. “If Shuanghui International acquires Smithfield Foods and sells the meat at high prices to Shuanghui Development, this will increase profits for the privatised Smithfield, but may not do much to help Shuanghui Development,” he predicts.

A further possibility is that having to service the LBO debt could curtail much of the investment envisaged by those who see the Smithfield purchase as a game-changing move for the industry. Of course, if it all goes to plan, the bid for Smithfield might turn out to be a game-changer for a small group of highly leveraged investors.But the jury must still be out on whether it will be quite so transformational for China’s domestic meat industry at large.

 

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China PE value-added: Empty promises? AVCJ

Fin

Author: Tim Burroughs

Asian Venture Capital Journal | 22 May 2013 | 15:47 secure

Tags: Gps | China | Operating partners | Buyout | Growth capital |Lunar capital management | Cdh investments management | Citic capital partners | Kohlberg kravis roberts & co. (kkr) | Jiuding Capital | Hony capital

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       China value-add: Empty promises?

Pulled by a desire to buy and build or pushed by a need to address restricted exit options, PE firms in China are placing greater emphasis on operational value-add. LPs must decide who’s all talk and who is action

By the time Harvard Business School published its case study of Kunwu Jiuding Capital in December 2011, the investment model being celebrated was already fading.

Within four years of its launch, the private equity firm had amassed $1 billion in funds and 260 employees, having turned itself into a PE factory “where investment activities were carried out in a way similar to large-scale industrial production.” Jiuding’s approach focused on getting a company to IPO quickly and leveraging exit multiples available on domestic bourses; and then repeating the process several dozen times over. With IRRs running to 500% or more, an army of copycats emerged as renminbi fundraising jumped 60% year-on-year to $30.1 billion in 2012.

But the average price-to-earnings ratio for ChiNext-listed companies had slipped below 40 by the end of 2011, compared to 129 two years earlier; SME board ratios were also sliding. Already denied the multiples to which they were accustomed, nearly a year later these pre-IPO investors were denied any listings at all as China’s securities regulator froze approvals.

The Harvard Business School case study noted that concerns had been raised about the sustainability of the quick-fire approach, given that some of these GPs appeared to lack the skills and experience to operate in normalized conditions. “The short-term mentality creates volatility,” Vincent Huang, a partner at Pantheon, told AVCJ in October 2011. “A lot of these GPs don’t have real value to add and so they won’t be in the market for the long run.”

Subsequent events have elevated the debate into one of existential proportions for pre-IPO growth capital firms. Listings will return but it is unclear whether they will reach their previous heights: the markets may be more selective and the valuations more muted.

There is also a sense that GPs have been found out lacking a Plan B; renminbi fundraising dropped to $5.1 billion in the second half of 2012. The trend is reflected on the US dollar side as the slowdown in Hong Kong listings over the course of the year left funds with ever decreasing certainty over portfolio exits. If GPs – big or small – face holding a company for longer than expected, what are they going to do with it?

“We value control and we can take advantage of the M&A markets if we have it. We also like the IPO markets here but any investment where we aren’t a controlling shareholder, we can’t set down the timetable for exit,” says H. Chin Chou, CEO of Morgan Stanley Private Equity Asia. “We ask ourselves, ‘Do we like holding this investment for five years because there is no IPO? At some point the IPO market will come back but until then you have to be very comfortable holding it.”

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China private equity bitten again by Fang — Financial Times

FT

 

 

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By Simon Rabinovitch in Beijing

Financier Fang Fenglei is betting on private equity recovery

China’s unruly markets have vanquished many a savvy investor, but if one man knows how to play them it is Fang Fenglei.

From the establishment of the country’s first investment bank in 1995 to the complex partnership that brought Goldman Sachs into China in 2004 and the launch from scratch of a $2.5bn private equity fund in 2007, Mr Fang has been at the nexus of some of the biggest Chinese deals of the past two decades.

Even his abrupt decision in 2010 to start winding down Hopu, his private equity fund, was impeccably well timed. Since he left the scene, the Chinese stock market has been among the worst performers in the world and the private equity industry, once booming alongside the country’s turbocharged economy, has gone cold.

So the news that Mr Fang, the son of a peasant farmer, will return with a new $2bn-$2.5bn investment fund is more than a passing curiosity. The financier is betting that China’s beleaguered private equity industry will recover – a wager that at the moment has long odds.

The most immediate obstacle for the private equity industry in China is a bottleneck on exits from investments. Regulators have halted approvals for all initial public offerings since October, a tried and tested method for putting a floor under the stock market by limiting the availability of shares. But a side effect has been eliminating the preferred exit route of private equity companies.

Even before the IPO freeze, the backlog was already building up. China First Capital, an advisory firm, estimates that there are more than 7,500 unexited private equity investments in China from deals done since 2000. Valuations may have appreciated greatly but private equity groups are struggling to sell their assets.

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Goldman Sachs Predicts 349 IPOs in China in 2013 — Brilliant Analysis? Or Wishful Thinking?

We’re one-quarter of the way through 2013 and so far no IPOs in China. Capital flows to private companies remain paralyzed. Never fear, says Goldman Sachs. In a 24-page research report published January 23rd of this year (click here to read an excerpt), Goldman projects there will be 349 IPOs in China this year, a record number. Its prediction is based on Goldman’s calculation that 2013 IPO proceeds will reach a fixed percentage (in this case 0.7%) of 2012 year-end total Chinese stock market capitalization.

This formula provides Goldman Sachs with a precise amount of cash to be raised this year in China from IPOs: Rmb 180bn ($29 billion), an 80% increase over total IPO proceeds raised in China last year. It then divvies up that Rmb 180 billion into its projected 349 IPOs,  with 93 to be listed in China’s main Shanghai stock exchange, 171 on the SME board in Shenzhen, and 85 on the Chinext (创业板)exchange. To get to Goldman’s numbers will require levels of daily IPO activity that China has never seen.

The report features 35 exhibits, graphs, charts and tables, including scatter plots, cross-country comparisons, time series data on what is dubbed “IPO ratios (IPO value as % of last year-end’s total market cap)”. It’s quite a statistical tour de force, with the main objective seeming to be to allay concerns that too many new IPOs in China will hurt overall China share price levels. In other words, Goldman is convinced a key issue that is now blocking IPOs in China is one of supply and demand. The Goldman calculation, therefore, shows that even the 349 new IPOs, taking Rmb180 billion in new money from investors, shouldn’t have a particularly adverse impact on overall share price levels in China.

I’ve heard versions of this analysis (generally not as comprehensive or data-driven as Goldman’s) multiple times over the last year, as China IPO activity first slowed dramatically, then was shut down completely six months ago. The CSRC itself has never said emphatically why all IPOs have stopped. So, everyone, including Goldman,  is to some extent guessing. Goldman’s guess, however, comes accessorized with this complex formula that uses December 31, 2012 share prices as a predictor for the scale of IPOs in 2013.

I’m grateful to a friend at China PE firm CDH for sending me the Goldman report a few days ago. I otherwise wouldn’t have seen it. I’m not sure if Goldman Sachs released any follow-up reports or notes since on China IPOs. Goldman was the first Wall Street firm to win an underwriting license in China. It’s impossible to say how much Goldman’s business has been hurt by the near-year-long drought in China IPOs.

Goldman shows courage, it seems to me, in making a precise projection on the number of IPOs in China this year, and relying on their own mathematical equation to derive that number. Here’s how all IPO activity in China since 1994 looks when the Goldman formula is plotted:

 

 

 

 

 

 

 

 

 

 

 

I’m not a gambling man, and personally hope to see as many IPOs as possible this year of Chinese companies. Even a fool knows the easiest way to lose money in financial markets is to be on the other side of a bet with Goldman Sachs. That said, I’m prepared to take a shot.  I’d be delighted to make a bet with the Goldman team that wrote the report. A spread bet, with “over/under” on the 349 number. I take the “under”. We settle up on January 1, 2014. Any takers?

My own guess – and that’s all it is –  is that there will be around 120 IPOs in China this year. But, this prediction admittedly does not rely on any formula like Goldman Sachs and so lacks exactitude. In fact, I approach things from a very different direction. I don’t think the only, or even main,  reason there are no IPOs in China is because of concerns about how new IPOs might impact overall share prices.

I put as much, or more, importance on rebuilding the CSRC’s capacity to keep fraudulent companies from going public in China. The CSRC seems to have had quite stellar record in this regard until last summer, when a company called Guangdong Xindadi Biotechnology got through the CSRC approval process and was in the final stages of preparing for its IPO. Reports in the Chinese media began to cast doubt on the company and its finances. Within weeks, the Xindadi IPO was pulled by the CSRC. The company and its accountants are now under criminal investigation.

The truth is still murky. But, if press reports are to be believed, even in part, Xindadi’s financial accounts were as fraudulent as some of the more notorious offshore Chinese listed companies like Sino-Forest and Longtop Financial targeted by short sellers and specialist research houses in the US.  The CSRC process — with its multiple levels of “double-blind” control, audit, verification —   was designed to eliminate any potential for this sort of thing to happen in China’s capital markets.

But, it seems to have happened. So, in my mind, getting the CSRC IPO approval process back on track is a key variable determining when, and how many, new IPOs will occur this year in China. This cannot be rendered statistically. The head of the CSRC was just moved to another job, which complicates things perhaps even more and may lead to longer delays before IPOs are resumed and get back to the old levels.

How far is the CSRC going now to try to make its IPO approval process more able to detect fraud? It has instructed accountants and lawyers to redo, at their own expense, the audits and legal diligence on companies they represent now on the CSRC waiting list.  Over 100 companies just dropped off the CSRC IPO approval waiting list, leaving another 650 or so stranded in the approval process, along with the 100 companies that have already gotten the CSRC green light but have been unable to complete their IPO.

A friend at one Chinese underwriter also told us recently that meetings between CSRC officials, companies waiting for IPO approval and their advisers are now video-taped. A team of facial analysis experts on the CSRC payroll then reviews the tapes to decide if anyone is telling a lie. If true, it opens a new chapter in the history of securities regulation.

If, as I believe,  restoring the institutional credibility of the CSRC approval process is a prerequisite for the resumption of major IPO activity in China, a statistical exhibit-heavy analysis like Goldman’s is only going to capture some, not all, of the key variables. Human behavior, fear of punishment, organizational function and dysfunction, as well as darker psychological motives also play a large role. An expert in behavioral finance might be more well-equipped to predict accurately when and how many IPOs China will have this year than Goldman’s crack team of portfolio strategists.

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

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.

 

 

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

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

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

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

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

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

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

Too Few Exits: The PE Camel Can’t Pass Through the Eye of China’s IPO Needle

The amount of capital going into private equity in China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors,  remains puny in China. 

This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. No one has yet focused on this issue. But, it is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China. 

Here’s a way to understand the problem: there is probably now over $50 billion in capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. 

At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Thousands of companies are waiting for approval, and thousands more will likely join the queue each year by submitting IPO applications to the CSRC.

Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRC’s primary role is to assure the stability of China’s capital markets, not to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. 

Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, it’s generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$20 million, that are most welcome.

In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, “Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread.”

Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias.  Bad Chinese companies go where good companies dare not tread. 

For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. That’s fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms’ overall investment performance.

Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove impossible for these firms to do as well with new money as they did with the old. 

These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newly-established Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. 

When I discuss this with PE partners, the usual answer is they expect exits through M&A to increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. I do agree that the percentage of Chinese PE deals achieving exit through M&A will increase from the current level. It could barely be any lower than it is now.

But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal,  the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. 

Measured by new capital raised and investment results achieved, China’s private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year,  the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will be a little less comfortable if, as seems likely,  a diminishing number of the investments made in Chinese companies have a big IPO payday.

 

 

 

How PE Firms Can Add – or Subtract – Value: the New CFC Research Report

China First Capital research report

CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report

China is awash, as nowhere else in the world is,  in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China. 

In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the same”. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not. 

In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.

They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy. 

But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away? 

These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.

These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company. 

It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments. 

Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investors”.

Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.   

Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business.  In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.

chart1

The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.

While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment. 

In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO. 

At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention. 

The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.