China economy

Alibaba’s Taobao and Other Online Shopping Sites are Pushing Traditional Retailers in China Toward Extinction

2 Comments / April 10, 2014

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Welcome to the desolate future of mall retailing in China.

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China shopping mall–

This seven-story skylit shopping mall occupies a premier spot in a high-rent commercial district in booming Shenzhen’s main shopping street, with a huge underground parking lot and entrances that link it directly with a busy Metro stop. And yet,  everywhere you walk, floor after floor, retail shop fronts are boarded up, with most stores closed down. Only the ground floor supermarket, top floor Multiplex movie theater, basement chain restaurants and a large Starbucks are thriving. Thousands of square meters of retail space, fully rented as recently as twelve months ago at some of the highest commercial rents in the world, are silent and vacant. No customers, no tenants, no rent income.

Malls are starting to empty out in China, but Chinese are richer, and spending like never before. Overall, retail sales rose 13% in 2013. The paradox can be explained by a single word: Taobao.  It is China’s largest online shopping business, and the anchor asset of Alibaba Group, now preparing for one of the world’s richest-ever IPOs on the US stock market. Taobao, along with its sister site TMall, and a host of smaller online retailers including Jingdong, Amazon China and Wal-Mart-controlled Yihaodian, have landed like an asteroid, and are wiping out the ecosystem supporting traditional retail in China, especially brand-name clothing shops.

The impact of online shopping in China is already far more wide-ranging than anything seen in the US or elsewhere. The reason is price. Taobao and others sell the same brand-name products available in shopping malls, but at prices often 30%-50% cheaper.  More even than rising incomes, online shopping is the most powerful force in China for raising ordinary Chinese living standards and purchasing power.

Online shopping is everywhere in the world, at its heart, a price discovery tool. And Chinese are now discovering, in their hundreds of millions, they have been getting seriously ripped off by traditional stores, especially those selling foreign and domestic brand-name clothing and consumer electronics. They usually occupy 70% or more of a mall’s retail floor space.

Alibaba and other online merchants are joyously surfing a tidal wave of dissatisfaction with the high price of store shopping in China. Not only are brick-and-mortar stores’ prices much higher than buying online, they are also often more expensive, in dollar-terms, than the same or similar Made-in-China products sold at Wal-Mart or Target in the US.

Those two giant chains have fought back against online retailers in the US by using their buying power to offer brand name products at low prices. No retailer in China is really attempting this. Retailing in China is both fragmented and uncreative. As dynamic and innovative as China is in many industries, I’ve yet to see even one great home-grown retailing business here in China.

There’s also a big problem in the way Chinese shopping malls, especially high-end ones, are operated. Chinese mall owners are mainly a motley assortment of one-off developers who used government contacts to nab a valuable piece of commercially-zoned downtown land at a fraction of its market value. They then mortgaged the property, built a fancy shopping palace, and now take a cut of sales, along with a baseline rent. This revenue-sharing discourages retailers from cutting prices. If they do, they will fail to meet the landlord’s minimum monthly turnover figure.

Compounding the pressure on traditional retailers, mall owners often give the best ground-floor locations to global brands like Louis Vuitton or Prada, who pay little or no rent, but are meant to give the mall a high-class ambiance. The big luxury brands’ China outlets seem to have rather anemic sales, but use their China stores as a form of brand promotion richly subsidized by mall owners. Domestic brands are shunted to higher floors. Fewer shoppers venture up there, and so the stores will often end up failing.

The result, as in the photo above taken on a recent Sunday, floor after floor of vacant space. China is creating an entire new retail landscape – a glamorously-appointed mall in a nice part of town whose upper floors resemble downtown Detroit after a riot, with boarded-up shop fronts and scarcely a soul.

Anywhere else in the world, a mall with so much vacant space would either need to cut rents drastically or hand the property over to the banks that lent the money. Neither is happening. For now, the banks can often afford to be patient. Malls that have been around for a few years have probably already paid off the loan principal. Newer loans look far shakier. There are hundreds of bank-financed high-end malls now under construction or opening this year across China.

The stampede away from malls is only just beginning. Though China has already overtaken the US in dollar terms as largest online shopping market, there is every sign that the shift to buying online is accelerating and irreversible. Online sales in China should reach 10% of total retail sales this year, well above the US level of 6%. We project this percentage will rise to over 15% within the next decade. That’s because more Chinese will shop online, especially using their mobile phones, and because the range of items that are cheaper to buy online is so much larger in China than anywhere else.

For that, online merchants must also thank the country’s parcel delivery businesses, led by Shunfeng Express. They charge so little (about one-tenth the price of Fedex or UPS) and are so efficient in getting your parcel into your hands quickly that it makes economic sense not only to buy higher-priced apparel and consumer electronics, but also packaged food, soap, personal care items, even knickknacks that sell for less than $1.

The retail stores that remain in shopping malls are increasingly being used as free showrooms to facilitate sales by online competitors. Chinese shoppers go to stores to find what they like, try it on, check the price, then go home and buy direct from Taobao. That’s one reason malls are still drawing crowds.

Online shopping is not only cheaper, customer service is usually much better. Most merchants selling on Taobao manage and run their own online shops. Taobao is nothing more than an aggregation of millions of motivated individual entrepreneurs. They are available just about any time, day or night, by phone or online chat to answer questions, or even, when asked, offer an additional discount. They are, in my experience, smart, self-confident, friendly, competent.

Sales help in stores are often poorly-paid younger women who cling together behind the cash register. They clearly don’t much enjoy what they are doing, nor are they there to enhance the shopping experience. Often just the opposite.

So what’s going to happen to all the malls in China? There are over 2,500 across the country, already more than double the number of enclosed malls in the US. More are opening around China every week. Who will fill up all the space? There’s serious money to be made by investors or operators who can take advantage of the large disruptions now underway in traditional retailing.

Restaurants in malls are still doing well, and they don’t have anything to fear from Taobao. But, food outlets generally pay lower rent, per square foot, than retail stores and occupy either the top or basement floors. Premium office space is also still in demand in the downtown areas where many malls are located. Should malls be turned into food and entertainment centers? Or converted to commercial offices? Neither path looks easy.

The US went through a large wave of shopping mall bankruptcies in the 1990s, as large operators like DeBartolo and Campeau failed, and better ones like Simon Property Group and Westfield Group thrived. The good operators lowered costs, improved the economics and did well as newer retailers like Victoria’s Secret, Abercrombie & Fitch, Hollister, Juicy Couture, H&M, Apple, Papyruys, Teavana, Nordstrom honed retail formulas that could withstand online competition.

Retailers in China are in such peril because they charge too much, never innovate and do so little to win the loyalty of their customers. Alibaba and other online sellers are hastening them towards extinction.

 

 

 

3M in China: A Magnificent Minnesota Multinational

1 Comment / August 9, 2017

3M China picture, China First Capital

 

Through pain comes wisdom.  US manufacturing giant 3M has a superb business in China that by sales, growth, product diversification, brand equity, market share and margins must place it among the very best, if not the best, US companies operating here.

This overdue realization came courtesy of having a nasty little cavity filled in China. As I squinted through the pain, I saw my dentist reach for a small tube of 3M-branded epoxy to fill up the hole in my tooth. “3M is American, like you, right?” she asked in Chinese. “This is the best product on the market.”

Dentistry didn’t really much exist in China until around 20 years ago. Since then, the growth has been hypersonic. Today there are about 60% more dentists in China than in the US, 135,000 compared to 85,000. The number of dentists is growing by 15,000 a year in China. 3M helped build the dentistry market from the ground up, and now enjoys a level of market penetration and trust in China exceeding the US.

Dental products are just one among many dozens of areas where 3M has built a large and profitable business in China. Another one I know of: reflective tape used on traffic signs and glow-in-the-dark clothing worn by police and other first responders. 3M enjoys something like a monopoly here, during a time when no other country is adding as many miles of roads, and as many bright new road signs as China. I have a Chinese client that tried, without much success, to compete with 3M in the market. Despite having better government contacts and lower prices, this Chinese company has gotten steam-rollered by 3M in China.

In industrial adhesives, photovoltaic components and, of course, Post-It Notes, the situation is the same. 3M has flattened every Chinese competitor that came after it. 3M’s China strategy is as simple as it is successful: premium products, prices and market shares.

3M has been in the PRC since 1984, almost as long as the country has welcomed American investment. Over that time quietly but oh-so efficiently, it has built a powerful business in China, with revenues last year growing 16% to over $3 billion. China sales are growing three times faster than overall 3M revenue. The company’s local CEO is on the record predicting 3M’s revenues in China will overtake its sales in the US ($9.5 billion in 2013) within the next ten years.

That would be a helluva achievement. But, I wouldn’t bet against 3M.  It has as strong a platform for growth in China as any company I know of, domestic and international. It sells hundreds of different products in over eighty separate product categories in China. In a county where no company’s intellectual property (patents and know-how) is meant to be safe from pirates, 3M has defended its secrets, and stayed comfortably ahead of local brand knock-offs and copycats. Counterfeiting is a separate issue, and probably 3M’s biggest problem in China.

In a way few, if any, other US multinationals have, 3M has managed to achieve significant sales and a stellar reputation both in consumer and B2B markets. As China grows richer, 3M’s strategy looks smarter and smarter. Cheap, low-quality products are being driven out of the market here. Consumers, factories and government departments are trading up. This leaves many low-end Chinese brands in a very difficult and life-threatening position. They can only compete on price in a market that’s increasingly price-insensitive. 3M is precisely the kind of manufacturing company China most sorely lacks – a serial innovator with branded products that can command higher prices.

Both my dentist and my handyman still stock lower-quality Chinese-made products. They offer customers a choice – something I never ran across living in the US. You want the good imported stuff or a cheap knockoff? The price difference can be rather high. For cavity-filling compound, using 3M product will cost you about three times as much. To fix a chair leg using 3M glue it’s double the price. But, both my dentist and my handyman say almost none of their clients are opting for the local brands.

3M is admired just about everywhere for the quality of its products. But, in China, it has an almost saintly reputation. During the height of the SARS epidemic in 2003, 3M disposable masks were widely publicized in the Chinese media as the most effective way to prevent the deadly disease. Today, 3M disposable masks are widely used by Chinese for another purpose, to block out the pollution and fumes that envelop big northern cities like Beijing, Jinan and Shanghai.

Other US companies with large China businesses have hit on tough times lately in China. P&G and Coca-Cola Company are losing market share to local competitors. Yum! Brands and Mondelez have both suffered from perceptions they peddle unhealthy food. Their best days in China, from my vantage point,  are probably behind them.

3M, meanwhile, quietly and steadily goes from strength to strength. If any US company can add another $7 billion in revenue in China over next decade, 3M is the most likely.

3M not only introduced its products to China, it also transplanted its rather unique American Midwestern personality. 3M China is, by local standards, modest, self-effacing, even dull. It doesn’t advertise much, or throw its weight around as one of the largest US companies operating here. The Maplewood, Minnesota-based parent barely even mentions China in its 2013 10-K annual report. When you are doing this well in the world’s strongest-growing major market and beating up your competitors, why crow about it?–

 

How China buried India

5 Comments / May 25, 2014

Forbes India cover story 1994

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Twenty years ago, India, not China, was the object of my absolute and total focus.  Back then, I was living in London and working as a European bureau chief for Forbes Magazine. In May 1994, a story I co-wrote called “Now We Are Our Own Masters” appeared on the cover of Forbes (click here to read the article). It was the first time a big American magazine took the risk to suggest India, after so many years of pathetic growth, famine and unending poverty, was ready for an economic take-off. It turned out to be a smart call. Since then, India’s economy has surged, growing seven-fold while poverty has declined steeply.

India GDP growth 1950-2010

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I spent about a month in India researching the article, meeting with political and business leaders. It was my third trip to the country. The first had been in 1978, as a young backpacking college student, on my way back to the US from a summer in Taiwan studying Mandarin. The two most vivid memories of that first trip — nearly dying from untreated amoebic dysentery, and hiding out for days in a place called Aurangabad as masses of Indian men rioted on the streets against the forced sterilization policy of India Gandhi. (Life lesson learned at 19: political popularity will be short-lived wherever a leader orders men at gunpoint to undergo genital surgery.)

It took another three years before I first set foot in China. On a lot of levels, the two countries struck me as similar back then, both in the extent of the obvious poverty as well as the shared disappointment some thirty years after each had gained full independence as socialist states under charismatic intellectual leaders, Jawaharlal Nehru in India and Mao Zedong in China.

China began its reform process a decade earlier than India. I caught the first stirrings when I arrived in Nanjing as a student in 1981. When I went to India in 1994 for the Forbes article, it still seemed plausible India might one day emerge as the larger, more vibrant of the two economies. China had suffered a sharp setback in 1989, during the Tianmen Square Protests of 1989, an event I witnessed first-hand in Beijing. At the same time, India had begun at last to liberalize and energize its over-regulated and inefficient state-run economy.

While India’s growth has since surpassed my optimistic hopes in 1994, I firmly believe it will never rival China. This chart below shows how far the gap between the two has grown. Since 1994, China has all but left India behind in its tailpipe exhaust.

China vs. India GDP Growth 1960-2010

In per capita PPP terms, China is now almost 2.5 times wealthier than India. Year by year, the gap grows, as China’s gdp expands faster than India’s, while India’s birth rate is now almost triple China’s.

I haven’t been back to India since 1994. I have no doubt it’s changed out of all recognition. Changed for the better. Poverty is down. Exports are way up. Its biggest misfortune may be having to compete for capital, and for attention, with China.

Living full-time and working in China now for more than four years, I’m more impressed than ever how superbly China is engineered for rising prosperity. The comparisons I read between India and China generally give a lot of weight to the difference in political systems, between India’s raucous federal democracy with dozens of parties and China’s one-party centralized rule. The indisputable conclusion: sound economic policies are easier in China to design and execute.

The few times I’ve been asked to contrast the two countries, I prefer to focus on their most valuable long-term assets.  India has English. China has Confucius.

India doesn’t out-compete China in too many industries. But, in two of these — pharmaceuticals and computer software — English is probably the main reason. India’s educated population is basically native fluent in the language. China has tried to make more of a game of it, especially in computer software and services. But, China is now and will likely remain a bit player in these two large, global high-margin industries.

India also has, overall, a more innovative financial services industry. This isn’t really the result of widespread English, but the fact that India has a more open financial and currency system than China’s.

Both nations benefit from having large diasporas. In India’s case, it’s a huge source of cash, with remittances of over $65 billion a year, equal to 4% of gdp. In China, the benefits are as much in kind as in cash. Companies owned or managed by ethnic Chinese from Southeast Asia, Hong Kong, Taiwan and the US have been large corporate investors in China, with the capital matched by transfer of technologies and manufacturing know-how. This is an ever-renewing remittance, as money pours in each year to finance projects with solid long-term rates of return.

China’s trump card, though, is its Confucian value system. Its potency as an economic force is amply demonstrated by the affluence of China’s Confucian neighbors, not just Hong Kong, Singapore and Taiwan, but South Korea and Japan. Its impact is measurable as well in the outsized economic clout of Chinese immigrants in Thailand, Philippines, Indonesia. Free market capitalism and Confucianism. Anywhere in the world you find sustained economic success and rising prosperity, you will find at least one. In China, they are entwined in a kind of ideal synthesis.

India, too, has close-knit families and a tradition of thrift and obedience. Confucianism adds to these a reverence for education and practical problem-solving. It contains nothing transcendent, not much, if any,  spiritual guidance for a soul-searcher make sense of his place in the cosmos. Honor your ancestors with burnt offerings, sweep their graves at least once-a-year and they’ll grease the wheels of success in this life.

The Confucian system hasn’t changed much for two thousand years. One vital adaptation over the last century, though,  was to accept that women could, and should, play an active role outside the house, reaching the same educational level as men and joining the workforce in equal numbers. Here, India is woefully far behind. China’s growth has been on steroids these past twenty years because its 650 million women have contributed exponentially more to economic growth and prosperity than India’s.

Of the couple hundred stories I wrote while at Forbes, I’m probably proudest of this India cover story published twenty years ago. It may not seem like it now, but it was a gamble to suggest back then under my byline India was about to come out of its long economic coma. Imagine if instead I’d gone on the record 20 years ago to forecast the coming economic miracle in Russia, Mexico or South Africa – all countries back then seen by some to be “the next great emerging market”.  I heard afterward the article helped generate more interest in India’s economic reforms and ultimately more investment in India by US multinationals. This grew about 30-fold in the ten years after the article appeared.

On a personal level, I made a larger, and I think even safer bet with my own professional life, to move to China and start a business here. Yes, India has English. I work every day in an alien tongue and in a culture steeped in Confucian values that play little or no part in my own ethical code. But, China was, is and shall long remain the great economic success story of all-time. I don’t need someone else’s magazine cover story to tell me that. I live it every day.

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China’s SOEs attract PE interest — Private Equity International Magazine

Leave a Comment / March 7, 2014

Private Equity International Magazine

www.peimedia.com

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China’s state-owned enterprise promise big returns for PE investors, as well as a big challenge.

By: Clare Burrows–

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In 2013, private equity investment in China dropped to just $4.5 billion – about 47 percent below the equivalent figure for 2012, according to data from Thomson Reuters. Since China’s dry powder level was estimated at $59 billion at the end of 2012, it’s clear that China’s GPs need to find new ways to deploy the vast amounts of capital raised during better times.–

What seems to be catching the industry’s eye more than ever are the country’s state-owned enterprises:large, government-controlled organisations, many of which are in dire need of restructuring. While state-owned enterprises account directly or indirectly for 60 percent of China’s GDP, according to research by China First Capital, almost 100 percent of institutional capital, especially private equity, has
been invested into China’s privately-owned sector.

However, as the number of traditional opportunities falls, “this may leave investing in SOEs as the best, largest and most promising new area for private equity investment,” Peter Fuhrman, chairman and chief executive at China First Capital suggests.–

And, some industry sources ask: what better target for private equity than these bloated, inefficient giants, which the newly-appointed Chinese government is apparently so keen to reform? SOEs are highly compliant when it comes to tax and accounting laws (a rare phenomenon among China’s privately-owned companies). Better still, they’re a bargain – because China’s State-owned Assets Supervision and Administration Commission (SASAC) regulates their price based on net asset value.–

“If you have a highly profitable SOE that has very low net assets, you can potentially buy it at incredibly low P/E multiples,” Fuhrman says. With one deal China First is advising on, 51 percent of the business is being offered at 2x EBITDA, he adds. China First is currently acting as an investment banker for five of China’s largest SOEs, including China Aerospace, China State Construction, China Huadian, Wuliangye Group and Shandong Energy.

Click here to read full article

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China’s New IPO Regime — manipulation or emancipation? — Reuters

Leave a Comment / June 24, 2016

Reuters

reuters

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In English we use the phrase ” bee in one’s bonnet” to explain someone with an obsession for a particular point of view. In Chinese, a similar idiom is 挥之不去, meaning you can’t wipe out the stain.

Have a  look at this article today by Reuters, about the IPO process in China. To me, the reporters started off this story with a bee in their hats, that China’s domestic IPO industry remains a nest of corruption, manipulation and ominous doings by the regulator, the CSRC. They found someone to quote, and then asked me for my opinion. I shared it across several emails. As you’ll see, I end up being quoted in the article providing something of an antidote to all the negativity. I don’t think, to switch back to the Chinese,  I quite wiped away the stain.

Here’s the story that didn’t get reported. In the last five weeks, China’s domestic stock markets had 48 successful IPOs. That is exactly 48 more than China had in all of 2013, and ahead of the successful IPOs so far this year in Hong Kong and the US. In my view, China is on track, as I said in one of those emails to the Reuters reporter, “to shatter all worldwide records for number of IPOs in a year and money raised.”

That’s big news. Instead, the article focuses on a whole lot else that all boils down to dark mutterings, but not a lot of facts, suggesting that insider trading  is or may become rife; that there’s some form of “moral hazard” at work here. Hard to refute. Equally hard to confirm.

The one example cited, of the cancelled Jiangsu Aosaikang, is said by a source to be “most heavily intervened IPO in the history of China”. IPOs, for those keeping score, get pulled all the time, everywhere, most often because investors wouldn’t commit to buying all the shares on offer. What happened with the Jiangsu Aosaikang IPO no one can say for sure. But, the quote is just silly.

Until two months ago, all China IPOs involved a level of direct, disclosed, intensive intervention by the CSRC that covered not only the IPO offering price, but included too the CSRC making decisions on which Chinese companies should IPO, when, with what level of profits. This was intervention on a grand, intentional and absolutist scale.

We’re only in the second month of the new IPO regime in China. Things might degenerate. The CSRC and market participants like underwriters are still feeling their way forward. But, there’s ample room for optimism here: a highly-damaging IPO embargo is over, Rmb 30 billion  ($5 bn) has been raised, and there’s clearly investor appetite for more new issues. –

Reuters

A Practical Peasant Revolution in China

1 Comment / February 11, 2014

Ming painting China First Capital

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It’s commonly held that the biggest threat to social stability, and therefore continued Chinese Communist Party rule, is a growing gap between rural and urban China. City folks grow prosperous while peasants struggle along in something akin to Neolithic poverty.  It’s a comfortable shorthand for understanding today’s China. But, it’s also increasingly far from the truth.

Rural China is undergoing a very powerful, if little noticed, transformation, as more agricultural production shifts to a system where peasants work for guaranteed cash wage to grow food. This is increasing incomes, as well as removing much of the risk from the traditional system where peasants would live off tilling their own small plot of land, and so be subject to all the hardships and vagaries that frequent unfavorable weather or adverse markets could deliver.

To be sure, there is still a  large gap in cash earnings of city and rural Chinese. This will likely always be true in China, as it is in the US and Europe. But, the gap in living costs is similarly large. You need far less money to live acceptably well in China’s countryside. The health care and education systems in rural China are also undergoing very powerful change, getting both better and cheaper for locals. While you can’t measure it precisely, because of huge differences in relative prices and purchasing power, my view is that the quality-of-life differential between city and rural China is fast getting narrower, rather than wider.

One primary force behind this change is the shift of more agricultural production to a wage-based system where peasants work as hired labor for the food, landscaping, Chinese medicine industries among others. In most cases, peasants are paid a guaranteed wage and given training as well as free fertilizer and pesticides to grow crops on their own land or fields leased by large companies. Beyond the basic wage, most will also earn bonuses depending on output. The bonuses may either be in cash or in kind: the peasant gets to keep and sell output above a pre-agreed minimum.

In Chinese, this rapidly-spreading agricultural contract production system is called 订单农业，”dingdan nongye“. It means farming done to fulfill fixed orders, at a fixed price, rather than growing things subject to the vagaries of nature and day-to-day market pricing. Deng Xiaoping gave peasants back their own land to farm. This new system is reducing much of the risk and struggle associated with peasant toil.

In Europe and the US, governments guarantee farmers a minimum income. But, their way of doing this is through market-distorting subsidies and protectionism that leads to higher food prices for consumers. The Chinese system is manifestly better.

In the last three years, I’ve visited quite a few companies and farming areas using this system as a key part of their business model. It is working well by all accounts, and spreading very quickly across rural China. From what I’m told, there is never a shortage of local peasants eager to participate in schemes like this. At a stroke, these peasants become fully part of the cash economy. Not only is the risk eliminated of suffering through a bad year, but it’s often possible for these peasants to work on, and profit from, a larger piece of land than their own small family plot.

In effect, this agricultural “putting out” system mirrors the way a lot of the manufacturing industry is organized in China. Manufacturing workers are given a fixed amount of work to do each month in return for a basic salary, and the promise of being paid regular bonuses for all output above the minimum. A similar system, for example, is in place at Foxconn, to encourage and reward all those thousands of workers turning out Apple iPads and iPhones.

In agriculture, this system solves one of a perennial problems both of Chinese farming and the Chinese food processing industry — small farm size, and so a lack of scale production. One example: I’m friendly with the boss of one of China’s largest brand-name “cellophane noodles” companies. They make vermicelli from sweet potato flour, a popular product across a lot of China. They need each year to secure an ever larger quantity of high-quality sweet potatoes. They can’t buy or rent an adequate amount of the land to farm themselves. So, they rely on a large number of Sichuan peasants to grow for them, based on annual contracts, with fixed salary and bonus.

A similar system is used by China’s largest producer of certain roots used commonly in Chinese medicine. The company now has about 35,000 acres under cultivation in an area of Northwestern China most suitable for producing these medicinal herbs. The local peasants have been growing these herbs for centuries, but with variable quality and unpredictable yields. The company has systematized the growing process. The impact on local peasant incomes has been profoundly positive.  In addition, it now means there is a reliable supply of high-quality pharmacologically-active plants being grown every year. The company provides seeds, fertilizer, and what’s known in America as “agricultural extension” — experts who work with local peasants to make sure everything is being grown efficiently, using the correct amount of fertilizer and irrigation.

The owner of this Chinese medicine herbs business also owns the largest beef processing company in this region of China. Here too, the basic production process is the same — peasants raise the cattle for the company, following strict standards, in return for salaries and bonuses.

The Chinese government, which is attentive to the need to improve rural living standards, is generally supportive of this agricultural contracting system. In some cases, they will also rent farm land to companies on condition that they use this wage-based system to employ local peasants. I have no first-hand knowledge of any skullduggery here, of peasants being turfed off their own land, so that they must take jobs working for some giant food company. Does it happen? Might it happen? China is a big country, with half a billion peasants. But, my sense is that overall, this new agricultural production system is an optimal way to increase incomes and decrease the toil and hardships of farming in China.

Along with helping peasants to live better, and drawing more peasants back home from factory jobs in urban areas, it’s also allowing agricultural processing companies to grow larger in scale, and increase the quality and distribution of their products. I have the opportunity to travel quite often in rural and semi-rural parts of China. I’m always struck, as an American, by the contrast between farmland in China and the US. America is blessed with so much fertile, flat and well-irrigated land.

In China, farmland discloses even to an untrained eye the fact it’s been in continuous cultivation for longer than just about anywhere else on the planet. The land looks tapped out, and chopped into parcels too small for machinery or efficient growing.  Nothing is going to change this. But, the new system of guaranteed wages, provided along with the necessary inputs or fertilizer and pesticide, is perhaps the most workable solution, as well as the one providing the most direct benefits to those who work the land.

Thirty-five years on, China’s market economy remains the most successful engine ever for lifting masses of farming people out of poverty.

 

 

The Misfortunes of the Big Four in China

1 Comment / January 29, 2014

China First Capital blog–

Last week, an SEC judge in the US delivered a spanking to the Big Four accounting firms, barring their Chinese affiliates for six months from doing audit work for US-quoted Chinese companies. “To the extent [the Big Four] found themselves between a rock and a hard place,” the judge’s decision declares, “it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow.”

Overall, the judge’s 112-page ruling on the audit work of the Big Four in China makes for interesting, and at times damning, reading. You can click here to access it.The judge’s decision should probably be required reading for anyone working in Chinese private equity and capital markets transactions with Chinese companies. Investments in Chinese companies worth many tens of billions of dollars rely, at least to some extent, on the accuracy and reliability of Big Four audits. That audit bedrock looks shakier now than it did a week ago.

The Big Four are appealing the decision meaning that for now at least, they can continue to serve their US-listed Chinese clients, continue to audit their accounts, and continue to earn sizable fees for doing so. If they lose the appeal, they will need to suspend for six months their main activity in China. The Big Four have a near-monopoly on audit work for the over 160 Chinese companies listed in the US. Will their Chinese clients permanently go elsewhere? What about the 15,000 people working for the Big Four in China? How will the firms pay them during the half-year suspension? How will they spend their working days if not engaged in audit work?

This much is clear: whatever happens with the appeal, the reputation and trustworthiness of the Big Four’s work in China has taken a recent beating. The judge’s decision last week is particularly ill-timed. Chinese companies have only just regained some of the lost trust of US investors, allowing IPOs to resume. I have friends at all Big Four firms, and have worked with all of them over the last six years in China.

This dispute between the SEC and the Big Four has been bubbling away for over two years. It was triggered by a series of SEC investigations into serious misbehavior by some Chinese companies then-quoted in the US — fraudulent financial accounts, incomplete disclosure, faked revenues. The companies were punished, and their shares delisted from the US stock exchange. But, what about the Big Four auditors? Why hadn’t they uncovered and reported their clients’ misconduct to the SEC? Were the Big Four in China careless?  Negligent? Or even complicit in these Chinese companies’ attempts to mislead US investors?

This quickly became a focus of the SEC investigation. To determine if the Big Four audits were performed thoroughly and in compliance with US securities laws, the SEC asked the Big Four in China for their audit papers — that is, the complete written documentation showing what they did and with what level of diligence and accuracy. The Big Four refused the SEC requests to hand over the audit papers, saying that to do so would violate Chinese state secrecy laws.

They used the same argument with the judge. He rejected it outright. Instead, he says the Big Four demonstrated “gall” in “flouting” the SEC, were “oblivious” to some core legal issues, and took a “calculated risk” they wouldn’t get punished. Strong stuff. While the judge doesn’t say directly that greed was a major factor in the Big Four’s decision to disobey SEC orders, but it may be fair to make that inference. Their strategy seems basically having one’s cake and eating it too. They wanted to keep earning big fees for China audit work, while not fully complying with US securities laws. In specific cases cited by the judge, accounting fraud at US-listed Chinese companies was first brought to light by short-sellers, rather than by the Big Four audits.

The judge’s ruling notes the fact that over the last decade, the Big Four have built very large businesses in China. KPMG China and Ernst & Young China both tripled in size from 2004-2012. PWC grew fastest, increasing its staff four-fold to over 8,000 people. Such rapid growth is unprecedented as far as I know in the history of large accounting firms.

One large irony here is that the Big Four are accused by the judge of violating Sarbanes-Oxley. That law has overall been very good to the Big Four, since it gave accountants increased responsibility to police US-listed companies’ financial accounts. The scope of audits increased and with it the fees. But, when things go wrong, as they have with quite a number of Chinese quoted companies listed in the US, the auditors can potentially be held legally liable.

The Big Four all argued to the judge they should be treated leniently because if banned, no other accountants in China have the training and professionalism to do audit work that meets SEC standards for investor protection.  Any Chinese company that can’t find a new auditor would need to delist from the US stock exchanges. The judge dismissed this argument, and helpfully lists a group of five other accounting firms that have done audits in China and, unlike the Big Four, turned over audit papers to the SEC when asked.

Some big US multinationals including P&G, Amazon.com, Apple, The Coca-Cola Company and Nike, with large revenues and operations in China, would probably also need to find new Chinese auditors if the ban is upheld. Investing or operating a US-owned business in China, never easy, will become even trickier if the Big Four are forced to down pencils in China and serve the six-month SEC suspension.

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China’s Capital Markets Go From Feast to Famine and Now Back Again, China First Capital New Research Report

Leave a Comment / January 19, 2014

China First Capital 2014 research report cover

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The long dark eclipse is over. The sun is shining again on China’s capital markets and private equity industry. That’s good news in itself, but is also especially important to the overall Chinese economy. For the last two years, investment flows into private sector companies have dropped precipitously, as IPOs disappeared and private equity firms went into hibernation. Rebalancing China’s economy away from exports and government investment will take cash. Lots of it. Expect significant progress this year as China’s private sector raises record capital and China’s state-owned enterprises (SOEs) gradually transform into more competitive, profit-maximizing businesses.

These are some of the conclusions of the most recent Chinese-language research report published by China First Capital. It is titled, “2014民企国企的转型与机遇“, which I’d translate as “2014: A Year of Transformation and Opportunities for China’s Public and Private Sectors”. You can download a copy by clicking here or visiting the Research Reports section of the China First Capital website, (http://www.chinafirstcapital.com/en/research-reports).

We’re not planning an English translation. One reason:  the report is tailored mainly to the 8,000 domestic company bosses as well as Chinese government policy-makers and officials we work with or have met. They have already received a copy. The report has also gotten a fair bit of media coverage over the last week here in China.

Our key message is we expect this year overall business conditions, as well as capital-raising environment,  to be significantly improved compared to the last two years.  We expect the IPO market to stage a significant recovery. Our prediction, over 500 Chinese companies will IPO worldwide during this year, with the majority of these IPOs here in China.

We also investigate the direction of economic and reform policy in China following the Third Plenum, and how it will open new opportunities for SOEs to finance their growth and improve their overall profitability, including through carve-out IPOs and strategic investment. SOEs will become an important new area of investment for PE firms and global strategics.

The SOEs we work with are all convinced of the need to diversify their ownership, and bring in profit-driven experienced institutional investors. For investors, SOE deals offer several clear advantages: scale is larger and valuations are usually lower than in SME deals; SOEs are fully compliant with China’s tax rules, with a single set of books; the time to IPO or other exit should be quicker than in many SME deals.

As financial markets mature in China, we think one unintended consequence will be a drop in activity on China’s recently-established over-the-counter exchange, known as the “New Third Board” (新三板）.  The report offers our reasons why we think this OTC market is a poor, inefficient choice for Chinese businesses looking to raise capital. While the aims of the Third Board are commendable, to open a new fund-raising channel for private sector companies, the reality is that it offers too little liquidity, low valuations and an uncertain path to a full listing on China’s main stock exchanges.

Over the last three years, China has had the highest growth rate and the worst performing stock market among all major economies. In part, the long stock market slide is both necessary and desirable, to bring China’s stock market valuations more in line with those of the US and Hong Kong. But, it also points to a more uncomfortable reality, that China’s listed companies too often become listless ones. Once public, many companies’ profit growth and rates of return go into long-term decline. IPO proceeds are hoarded or misspent. Rarely do managers make it a priority to increase shareholder value.

A small tweak in the IPO listing rules offers some promise of improvement. Beginning this year, a company’s control shareholder, usually the owner or a PE firm, will be locked-in and prevented from selling shares for five years if the share price stays below the original IPO level.

Spare a moment to consider the life of a successful Chinese entrepreneur, both SOE and private sector. In two years, access to capital went from feast to famine. And now maybe back again. An IPO exit went from a reachable goal to an impossibility. And now maybe back again. Meanwhile, markets at home surged while those abroad sputtered. Government reform went from minimal to now ambitious.

2014 is going to be quite a year.

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Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

pendant

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PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.– – –

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

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IPO rules overhauled for PE and VC firms — China Daily

Leave a Comment / May 1, 2014

China Daily article

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Shanghai stock exchange trading floor

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Friday, January 3, 2014

Private equity and venture capital firms will have to conduct their business differently in China in 2014, after regulators overhauled initial public offering rules.

Chinese PE and VC companies used to evaluate the companies by the standards of the China Securities Regulatory Commission for quicker IPOs, but now the market will play a more important role, said Peter Fuhrman, chairman, founder and chief executive officer at China First Capital.

“Under the new IPO system, the share pricing of an IPO company is decided by its strength and competitiveness, so investors will choose companies with real potential to invest in and provide them with the resources of strategy, management and market development to make their own return the best,” said Fuhrman *.

Private equity and venture capital firms will not find it easy to earn money any more after the new share-listing reform plan is carried out, because even if the companies they invested in get listed, they will still face the risk of losses, said Jin Haitao, chairman of leading Chinese equity investment firm Shenzhen Capital Group Co Ltd.

Jin said PE and VC institutions should cultivate real investment capabilities including those in value-discovery and negotiating. Pre-IPO deals cannot be guaranteed to earn money any more.

A total of 83 Chinese companies completed the examination and received approval from the China Securities Regulatory Commission. About 50 are expected to have finished all IPO procedures and be listed before the end of January. More than 760 companies are in line for approval. It will take about a year to audit all the applications.

In the IPO reform plan announced at the end of November, information disclosure has become more important and the China Securities Regulatory Commission will only be responsible for examining applicants’ qualifications, leaving investors and the markets to make their own judgments about a company’s value and the risks of buying its shares.

More and more Chinese companies applying for IPOs asked for cooperation with multinational accounting institutions, according to Hoffman Cheong, an assurance leader at Ernst & Young China North Region.

Cheong said the information disclosed can be different after the IPO reform plan is carried out.

According to the IPO reform plan, so long as an issuer’s prospectus is received by the commission, it will be released on the commission’s website. The company should buy back shares if there is a false statement or major omission. Also it should compensate investors if they lose money in certain situations.

http://www.chinadailyasia.com/business/2014-01/03/content_15109395.html

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(* Note: I never spoke to the reporter. As far as I can tell, the quote was translated into English, rather clumsily, from a Chinese-language commentary of mine published recently in a Chinese business publication. If asked, I would have said that companies need to choose PE investors carefully, and vice versa.)–

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SOE Reform in China — Big Changes On the Way

Leave a Comment / December 24, 2013

Qianlong emperor calligraphy

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China’s state-owned enterprises (SOEs) are a lucky breed, or so conventional wisdom would have it. They have lower cost of capital and less competitive pressures of private sector competitors. China’s big banks (also state-owned) are always happy to lend, and if things do turn sour, China’s government will bail everyone out.

The reality, however, is substantially different and substantially more challenging. SOEs live in a different world than they did ten, or even three years ago. They are more and more often under intensifying pressure to achieve two incompatible goals: to continue to expand revenues by 15%-25% a year, but to do so without corresponding large increases in net bank borrowing. The result, over time, will be that SOEs will need to rely increasingly on private sector capital to finance their future growth.

This message came through especially loud and clear in the policy document published by the Chinese leadership after the recent Third Party Plenum in November.  SOEs are told they need to become more attuned to the market and less dependent on government favors and protection. This new policy pronouncement is reverberating like a cannon blast inside the state-owned economy, based on conversations lately with the top people at our large Chinese SOE clients.

No one at these SOEs is entirely sure how to fulfill the orders from above. But, they are all certain, from long years of experience, that the environment SOEs operate in is going to undergo some significant change, likely the most significant since the “Great Cull” of the mid-1990s when thousands of SOEs were pushed into bankruptcy.Too many of the surviving SOEs have done little more than survive over the last twenty years. They managed to stay in the black, sometimes by resorting to rather idiosyncratic accounting that ignored depreciation.

The Chinese leadership is embarking on a tricky, somewhat contradictory, mission:  to simultaneously shake up the SOE sector, make it more efficient and responsive to market forces,  while keeping SOEs embedded in the foundation of China’s economy.  Much has changed about the way Chinese leaders view and manage SOEs. But, a key principle remains intact. The architect of the policy, Deng Xiaoping, put it this way, ” As long as we keep ourselves sober-minded, there is nothing to be feared. We still hold superiority, because we have large and medium state-owned enterprises.”

In other words, SOE privatization is not on the menu, at least not in any large-scale way. SOEs, particularly the 126 so-called “centrally-administered SOEs” (央企)  will remain majority-owned by the government. The government is suggesting, however, it wants these SOEs, as well as the other 100,000 or so smaller ones active in most parts of the Chinese economy, to be run better and more profitably. But how? That’s the a topic of discussions I’ve been having over the last month with the bosses at our SOE clients.

The rate of return (as measured by return on assets) at SOEs has, in almost all cases, drifted down over the last ten years, and is now probably under 3% a year.  If bank borrowing and depreciation were more properly amortized, the rate of return would likely turn negative at quite a lot of SOEs.

In some cases, this reflects the cruel reality that many SOEs operate in low-margin highly-commoditized industries. But, another key factor is that the government body that acts as the owner of most SOEs, SASAC (国资委), is not your typical profit-maximizing shareholder.

SASAC manages the portfolio of SOE assets like the most risk-averse executor. It demands three things above all from SOEs: don’t lose money;  don’t pilfer state assets and keep revenues growing.

When your owner sets the bar a few inches off the ground, you don’t try to break the Olympic high jump record. No SOE manager ever got a bonus, as far as I’ve heard, from doubling profits, or improving cash flow. Pay-for-performance is basically taboo at SOEs. The whole SOE system, as it’s now configured, is designed to produce middling giants with tapering profits.

Rather than shake-up SASAC, the country’s leaders have given SOEs a green light to seek capital from outside sources, including private equity and strategic investors. They should provide, for the first time, a voice in the SOE boardroom calling for higher profits, higher margins, bigger dividends.

It’s a wise move. SOEs need to carry more of the load for China’s future gdp growth. You can’t do that when you are achieving such low return on assets. Among the SOEs we work with, there’s a genuine excitement about bringing in outside investment, and operating under a new, more strenuous regime. Surprised? The SOEs I know are run by professional managers who’ve spent much of their careers building the business and take pride in its scale and professionalism. They, too, see room for improvement and see the downsides of SASAC’s approach.

Outside capital can help these SOEs finance their future expansion.  It could also open new doors, especially in international markets. The big question: can — will — private equity, buyout firms, global strategic investors seek out investments in Chinese SOEs? It’s unfamiliar terrain.

Earlier this year, I arranged a series of meetings for twelve of the world’s-largest PE firms and institutional investors to meet a large SOE client of ours. These firms collectively have over $700 billion in capital, and each one has at least ten years’ experience in China. They are all keen on this particular deal. Yet, none of these firms have invested in any SOE deals over the last five years. For many of the visiting PEs, it was their first time ever meeting with the boss of a profitable and successful SOE to discuss investing.

In this case, it looks like a deal will get done, and so provide a blueprint for future PE investing in Chinese SOE.  The Chinese leadership ordered a shakeup to the state owned sector. It’s getting one.

 

The Big Churn — How High Partner Turnover Damages China’s Private Equity Industry

Leave a Comment / December 12, 2013

China PE partner turnover –

What’s the biggest risk in China private equity investing?  Depends who you’re asking. If you ask LPs, the people who provide all the money that PE firms live off, you will often hear a surprising answer: turnover at PE firms. Nowhere else in the PE and VC world do you find so many firms where partners are feuding, quitting or being thrown off the bus.

A partnership at a PE firm was meant to be a long-term fiduciary commitment. In China, it rarely is. The result is billions of dollars of LP money often gets stranded, and possibly wasted. That’s because when a partner leaves, it often creates a bunch of orphaned investments. The departing partner is generally the only solid link between the PE firm and the investee company. Everyone left behind is harmed — the PE firms, the companies they invest in, and the LPs whose money is trapped inside these deals.

As the CEO one of Asia’s largest and most professional LPs told me recently, “Before committing to a new China fund, we spend more of our time trying to figure out how the partners get along than just about anything else. Will they hang on together through the life of the fund? We know from experience how damaging it is when partners fall out, when key people leave. We know turnover can mean we lose everything we’ve invested. And yet, we still often get stung. ”

In my nearly-twenty years in and around the PE and VC industry in the US, Europe and Asia, I’ve never seen anything quite like what happens here in China. A quick look through my Outlook contacts reveals that almost half the PE partners I know working in China have changed firms in the last five years. One reason you don’t see this elsewhere is that partners expect to earn carried interest on the deals they’ve made. If they leave, they forgo this.

Carry is a kind of unvested pay. On paper, it’s often quite sizable, and should represent the majority of a PE partner’s total comp, as well a kind of golden handcuff. The only reason for partners to leave is they believe they won’t get any of this money, either because of failed deals or, more commonly, large doubts that the head partner, the person running the firm, will share the rewards from successful deals.

Most China PE firms are partnerships in name only. There is usually one top dog, usually the founder and rainmaker. This person can unilaterally decide who stays, who goes, who gets carry and who gets a lump of coal. Top Dog tends to treat partners like overpaid, somewhat undeserving hired hands.

So, why have partners at all? Often it’s because LPs insist on it, that they want PE and VC firms in China to be structured like those elsewhere. The business card says “Partner” but the attitude, expectations and level of commitment say “Employee”.

Senior staff (VPs, Managing Directors) also frequently depart. In the US, you don’t often see that much, since these are the people in line to become partners, which is meant to be the crowning achievement of a long successful career in the trenches. They leave because they don’t believe they’ll be promoted, or if they are, that they’ll see any real change in their current status as wage-earners.

At a party celebrating a recent IPO of a PE-backed Chinese company, I ran into the PE guy who led the original investment, did all the heavy lifting. He had since left and joined another firm. He laughed when I asked why he would leave before the IPO, with his old firm certain to earn a big profit on his deal. “I don’t know who will get the carry, but I was sure it wouldn’t include me,” he explained.

Partners jump ship most often because someone is offering a higher salary, a higher guaranteed amount of pay. Their new firm will usually also offer them carry. Both sides will negotiate fiercely over the specific terms, what percent with what hurdle rate. And yet, more often than not, it seems to be a charade.

From day one, the new partners may already thinking about their next career move, how to trade up. Emblematic of this: here in China, when PE partners join a new firm, they almost always refer to it as “joining a new platform”. Note the choice of words: platform, not firm.

The LPs — and I speak to quite a lot of them — acknowledge, of course, that there are other big risks in China, that individual investments or even a whole portfolio turns sour. But, this is a risk inherent in all PE investing everywhere. High partner turnover is not.

If you’re interested, you can click here and read the email exchange I had recently with a newly-departed partner at one of China’s better-known VC firms. As I write there, I hate to sound like a scold. I know PE partners also want to earn a good living, and should work where they are happiest and best compensated. But, China’s PE industry serves a deeper economic purpose and holds in trust the assets of both investors and companies. “Looking out for Number One” should not be the only career goal of those working in senior levels in the industry.–

 

 

China’s IPO Freeze to Melt in Midwinter

Leave a Comment / December 2, 2013

Kesi embroidery

IPOs are returning to China. The China Securities Regulatory Commission this weekend announced its long-awaited guidelines on a new, somewhat liberalized process for approving IPOs. The rush is now on to get new IPOs approved and the money raised before Chinese New Year, which falls on January 31st, less than two months from now. Ultimately, the CSRC hopes to clear within one year the backlog of over 800 Chinese companies now with IPO applications on file. Thousands of other Chinese companies are waiting for the opportunity to submit their IPO plans. The CSRC stopped accepting new applicants almost 18 months ago.

From what I can tell, the CSRC has concluded, rightly, its old IPO approval process was broken beyond repair. The regulator used to take primary responsibility for determining if a Chinese company was stable enough, strong enough, honest enough to be trusted with the public’s money. No other securities regulator took such a hands-on, the “buck stops with me” approach to IPO approvals. The CSRC now seems prepared to pass the buck, in other words, to put the onus where it belongs, on IPO applicants, as well as the underwriters, lawyers and accountants.

This should eliminate the moral hazard created by the old system. Companies, as well as their brokers and advisors, had a huge amount to gain, and much less to lose, by submitting an application and hoping for a CSRC approval. They could cut corners knowing the CSRC wouldn’t. For the successful IPO applicants who got the CSRC green light, valuations were sky-high, and so were underwriting and advisory fees.

Going forward, the CSRC seems determined to switch from security guard to prosecutor. Rather than trying to detect and prevent all wrongdoing, it is now saying it will punish severely companies, and their outside advisors, where there’s a breach in China’s tough securities laws. The CSRC’s powers to punish any wrongdoing are significant. Heaven help those who end up being convicted of criminal negligence or fraud. As I noted before,  there are no country club prisons in China for white collar offenders.

While baring its sharp teeth, the CSRC is also now using its more soothing voice to tell retail stock market investors they will need to do more of their own homework. It wants more and better disclosure from companies. It hopes investors will read before buying. And, the CSRC also hopes the stock market will itself begin to provide investors will clearer signals, through share price movements, on which companies may not be suitable for the more risk-averse.

Up to now, companies going public in China did so with a kind of “CSRC Warranty”. That’s because the CSRC itself said it had already done far more detailed, forensic scrutiny of the company than just reading through its public disclosure documents. The approval process could take two years or more, with company execs, lawyers and accountants being called frequently to meetings at the CSRC headquarters to be grilled. All this to give comfort to investors that nothing was awry.

The warranty has effectively been revoked. This may make some investors more nervous, but it represents a significant and positive breakthrough for the CSRC.

It needs to lighten its grip. Markets need regulation, need rules and effective mechanisms for punishing bad actors. But, the CSRC took on too much responsibility for assuring the orderly functioning of China’s stock market. This was always going to be difficult. China’s stock markets are far more prone to speculative frenzy than stock markets in the US, Europe. Shares on the Shanghai and Shenzhen stock markets are bought and sold mainly by retail investors, or as the Chinese say, “old granddads and grannies” (老爷爷老奶奶）. Institutional investors are a minority. As for investment fundamentals, on China’s stock market there are mainly just two:  “Buy on rumor. Sell on rumor”.

Over the last year, I’ve written about problems at the CSRC that helped cause and prolong this long freeze in IPOs. The CSRC’s first instinct back in 2012 was to try to toughen its regulation, toughen its own internal systems and procedures for rooting out fraud. It then switched tracks, and decided to let the market play more of a role.  This is a major concession, as well as important proof that China’s larger process of economic transformation, of freeing rather than freezing markets, is headed in the correct direction.

As if on cue, this past week’s Wall Street Journal last week digested a section from the Nobel Prize acceptance speech by economist Friedrich Hayek.

“To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm…Even if such power is not in itself bad, its exercise is likely to impede the functioning of those spontaneous ordering forces by which, without understanding them, man is in fact so largely assisted in the pursuit of his aims. ”

I’m delighted China’s IPO market is going to re-open. My own prediction here a couple of months ago was that it IPOs would resume around now, rather than next month. This just goes to show all forms of market timing — whether it’s trying to guess when a stock price has hit its peak or when a stock market itself will change course, and its once omnipotent regulator change its entire approach — is a fool’s errand.

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Private Equity Secondaries in China — PEI Magazine Whitepaper

Leave a Comment / December 5, 2014

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Private equity dealflow continues to stall in China – but so far it hasn’t yet prompted the hoped-for explosion in secondary market activity

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Secondaries specialists have been busy in Asia lately. While firms such as LGT Capital Partners and Paul Capital have been doing secondaries deals from Hong Kong since 2007, in the last 18 months other firms such as Greenpark Capital, AlpInvest Partners and Lexington Partners have all been enhancing their Asia presence.

So far, secondary market activity in Asia has been more of a gradual flow than a wave of deals. But the changing macroeconomic conditions are increasing pressure on GPs – and that could result in more opportunities, particularly in China. Asia’s largest and most attractive market is losing some of its shine, thanks to a sustained slowdown in annual GDP growth and a frozen IPO market that has left GPs holding assets that they need to exit.

“If you could do [secondaries] at this moment – wow,” says Peter Fuhrman, chairman and chief executive of China First Capital. “In this market, some LPs could sell out for 10 cents on the dollar. For LP secondary buyers, it is nirvana: a distressed exit market, portfolios with solid growing businesses inside of them, and a group of somewhat distressed LPs. A lot of these LPs, even bigger ones who have their money in China, have lost faith.”

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Click To Read Full PEI Whitepaper Report on Private Equity Secondaries

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China’s Logistical Nightmare

1 Comment / November 14, 2013

China First Capital blog logistics in China

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China is modeling itself after the wrong part of the American economy. The money, the rhetoric and the policies are all focused on trying to replicate America’s lead in high-technology and innovation. Instead, China would be long-term much better off and its citizens enjoy immediate higher living standards if it copied something far more mundane from the US,  its distribution and logistics.  If China’s $9 trillion economy has an Achilles Heel, this is it. It simply costs too much to get things into consumers’ hands.

Wholesale layer is piled onto wholesale layer, with margin and fees extracted at every step. Fixers, expediters, overlookers all take a cut. Trucks are too small, tolls too high, warehouses too small, and road traffic too congested in major cities. Commercial and retail rents are high, relative to per capita income level. In China, there is enough “friction” in every retail transaction to start a bonfire.

Logistical costs and bottlenecks are the single biggest reason why so many goods made in China are sold at higher prices than in the US. This has more real-world consequences for average Chinese consumers than the level of the dollar-Renminbi exchange rate. It is logistics costs, all the stickiness and expense of getting products to market, that is most to blame for holding back the buying power, and so spending impulses, of Chinese consumers. Middlemen live well in China. Consumers less so.

It is cheaper, in many cases, to get a product made in China onto a container ship in Shanghai, offload it in Long Beach, truck it across the US, and then stock it on a shelf at a Wal-Mart in Georgia then it is to put the same product in front of Chinese consumers in a Wal-Mart in China. High taxes don’t help. China’s VAT, applied to most things sold at retail,  is set at a higher level than most sales taxes in the US. Another factor: retail competition as Americans know it is also largely absent in China. Stores don’t compete much on price in China. Wal-Mart won’t say, but it’s a fair assumption its margins in China are at least double those in the US.

But, high consumer prices in China are mainly the product of the high handling charges. A simple example. I eat a lot of fruit.  Most fresh fruit grown in China costs as much or more in supermarkets here than the same fruit grown and sold in the US.

Apples sell for around Rmb 6 (95 cents) per pound and up in China. The apple farmer gets around Rmb 1 per pound. The rest is liberally spread among all those standing between apple tree and my mouth.

Adjusted for purchasing power, Chinese average income levels are around 1/6th the US’s. So, that Chinese apple sells for equivalent, in US terms, of $6 a pound. That amounts to a lot of money per apple being shared by people other than the grower and the eater. How much? Chinese eat a lot of apples. In fact, almost half of all apples grown in the world are eaten in China, ten times more than total US consumption.

I met the boss of one of China’s largest apple shipping and packaging companies. Outside of China, this is a razor-thin margin business. But, the Chinese apple packer and shipper has profit margins well above 10%.

One of the most expensive links in the Chinese domestic supply chain are road tolls. China’s are among the most costly, per kilometer traveled, anywhere in the world. Trucks carrying agricultural products don’t pay tolls. Anything else moving along China’s highway system pays full freight. Depending where you are in the country, tolls run as high as 25 cents a mile for passenger cars. Trucks pay triple that. It all, of course, ends up being passed along to consumers.

To amortize the tolls, truckers overload their vehicles. This burns more fuel, degrades roadways (justifying still higher tolls), and makes loading and unloading more time-consuming and so more costly. According to the boss of a large long-distance shipping company I talked to, his trucks are routinely pulled over by traffic police and made to pay various on-the-spot fines. This can double the amount paid in tolls.

Everything about the logistics industry in China acts as a sponge soaking up consumers’ cash. The one exception: Shunfeng Express （顺丰快递）.  Little known outside China, Shunfeng Express is China’s most successful private shipping and delivery companies. It alone proves that logistics in China doesn’t need to be wasteful, expensive and inefficient.

Shunfeng is modeled after Fedex, DHL and UPS, but operates on a scale, and at prices, that would be unimaginable to these global giants. Shunfeng is a secretive outfit. Not much is publicly disclosed. The founder lives in Hong Kong, but comes originally from the mainland.  It was started in 1993, and according to some media reports, its net income in 2010 of Rmb 13 billion ($2.1 billion). That may be a stretch, but Shunfeng is doing a lot right and deserves whatever profit it keeps.

Shunfeng picks up and delivers documents, packages and some bulk freight between cities in China. It charges a fraction of what Fedex or UPS do in the US. These US companies are mainly prohibited to operate in China’s domestic delivery market. I’m not sure they’d be so eager. For next-day document delivery within a city, Shunfeng charges under $2. Delivery to other cities: $3. If you want to move a few kilos of freight, Shunfeng not only ship it, but will come and package it for you. That part is free. The shipping usually works out to less than $5 a kilo.

One of the main reasons Alibaba’s Taobao has become so successful in China is that Shunfeng ships Taobao purchases cheaply and efficiently across China. Taobao, which operates like a cross between Amazon Marketplace and eBay, will likely facilitate transactions worth around USD$100 billion this year. A lot of that will get shipped and delivered by Shunfeng.

They have an army of delivery guys. Most larger office buildings in major cities have one permanently stationed inside. You call for a pickup and the Shunfeng guy arrives within minutes. Most letters and packages get moved around by either electric motorcycle or jet. It leases its own aircraft to fly stuff around within China.

Shunfeng doesn’t do cross-country trucking. This is one big reason Shunfeng are so efficient and so cheap. Anything that moves by truck in China is going to have multiple hands in the till, and so end up costing consumers too much.

Shunfeng has achieved its massive scale and now well-known brand in China without raising capital from the stock market, or bringing in outside professional investors until three months ago. There are few private companies in China I admire more, and who are doing more to benefit the average consumer in China. I wish I could invest. For the good of every consumer in China, Shunfeng should continue to grow, continue to expand the range of what it handles in China. That will do a lot to unstick China’s logistical logjam.