China economy

Chinese IPOs Try to Make a Comeback in US — New York Times

Leave a Comment / June 24, 2016

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I.P.O./Offerings

Chinese I.P.O.’s Try to Make a Comeback in U.S.

BY NEIL GOUGH

HONG KONG — Chinese companies are trying to leap back into the United States stock markets.

The return, still in its early days and involving just a handful of companies, comes after several years of accounting scandals that pummeled their share prices and prompted scores of companies to delist from markets in the United States.

But the spate of recent activity suggests investors may be warming once more to Chinese companies that seek initial public offerings in the United States.

Qunar Cayman Islands, a popular travel website owned by Baidu, China’s leading search engine company, began trading on Nasdaq on Friday and nearly doubled in price. On Thursday, shares in 58.com, a Chinese classified ad website operator that is often compared to Craigslist, surged 42 percent on the first trading day in New York after its $187 million public offering.

The question now — for both American investors and the companies from China waiting in the wings to raise money from them — is whether these recent debuts are an anomaly or have truly managed to unfreeze a market that was once a top destination for Chinese companies seeking to list overseas.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm based in Shenzhen, China, said that for both sides, the recent signs of a détente between American investors and Chinese companies is “a matter of selectively hoping history repeats itself.”

“Not the recent history of Chinese companies dogged by allegations, and some evidence, of accounting fraud and other suspect practices,” he added. “Instead, the current group is looking back farther in history, to a time when some Chinese Internet companies with business models derived, borrowed or pilfered from successful U.S. companies were able to go public in the U.S. to great acclaim.”

That initial wave of Chinese technology listings began in 2000 with the I.P.O. of Sina.com and later featured companies like Baidu, which has been described as China’s answer to Google. In total, more than 200 companies from China achieved listings on American markets, raising billions of dollars through traditional public offerings or reverse takeovers.

But beginning about 2010, short-sellers and regulators started exposing what grew into a flurry of accounting scandals at Chinese companies with overseas listings. In some cases, such accusations have led to the filing of fraud charges by regulators or to the dissolution of the companies. Prominent examples include the Toronto-listed Sino-Forest Corporation, which filed for bankruptcy last year after Muddy Waters Research placed a bet against the company’s shares in 2011 and accused it of being a “multibillion-dollar Ponzi scheme.”

Concerns about companies based in China were reinforced in December when the United States Securities and Exchange Commission accused the Chinese affiliates of five big accounting firms of violating securities laws, contending that they had failed to produce documents from their audits of several China-based companies under investigation for fraud.

In response, American demand for new share offerings by Chinese companies evaporated, and investors dumped shares in Chinese companies across the board. It became so bad that the tide of listings reversed direction: Delistings by Chinese companies from American markets have outnumbered public offerings for the last two years.

Despite the renewed activity, it is too early to say whether Chinese stocks are back in favor. The listing by 58.com was only the fourth Chinese public offering in the United States this year, according to Thomson Reuters data. LightInTheBox, an online retailer, raised $90.7 million in a June listing but is trading slightly below its offering price. China Commercial Credit, a microlender, has risen 50 percent since it raised $8.9 million in August. And shares in the Montage Technology Group, based in Shanghai, have risen 41 percent since it raised $80.2 million in late September.

Still, this year’s activity is already an improvement from 2012, when only two such deals took place, according to figures from Thomson Reuters. Last month, two more Chinese companies — 500.com, an online lottery agent, and Sungy Mobile, an app developer — submitted initial filings for American share sales.

But the broader concerns related to Chinese companies have not gone away. In May, financial regulators in the United States and China signed a memorandum of understanding that could pave the way to increased American oversight of accounting practices at Chinese companies. But the S.E.C.’s case against the Chinese affiliates of the five big accounting firms remains in court.

The corporate structure of many Chinese companies is another unresolved area of concern. Because foreign companies and shareholders cannot own Internet companies in China, both 58.com and Qunar rely on a complex series of management and profit control agreements called variable interest entities. Whether such arrangements will stand up in court has been a cause for concern among foreign investors in Chinese companies.

And short-sellers continue to single out companies from China, often with great success.

In a report last month, Muddy Waters took aim at NQ Mobile, an online security company based in Beijing and listed in New York, accusing it of being “a massive fraud” and contending that 72 percent of its revenue from the security business in China last year was “fictitious.”

NQ Mobile has rejected the accusations, saying that the report contained “numerous errors of facts, misleading speculations and malicious interpretations of events.” The company’s shares have fallen 37 percent since the report was published.

(http://dealbook.nytimes.com/2013/11/01/chinese-i-p-o-s-attempt-a-comeback-in-u-s/?_r=1)
 
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Hong Kong IPO Today for China First Capital Client Hydoo

Leave a Comment / October 31, 2013

Hydoo Prospectus

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Welcome good news today from Hong Kong’s capital markets. The Chinese commercial real estate developer Hydoo (Chinese name 毅德) successfully IPOs on the Hong Kong Stock Exchange, raising over USD$200mn in new capital. With IPO channels for Chinese companies mainly blockaded, it’s especially welcome to see a Chinese private sector company raising so much from the stock market.  In this case, the delight is greater because Hydoo is a client of China First Capital. We acted as Hydoo’s investment bankers raising USD$80mn from Chinese private equity firm Hony Capital.  Hony’s 2011 investment, based on today’s IPO price, is now worth USD$150mn.

In addition to Hony, China’s giant financial services group Ping An also invested before IPO.  In total, Hydoo raised USD$140mn (Rmb 860mn) of institutional capital before IPO. Over 60% of the IPO shares (worth over $120mn) were sold by underwriters ahead of time to so-called “cornerstone investors“, including two large Chinese SOEs, Huarong and China Taiping Insurance, as well as retailer Suning (in which Hony owns a share).

I’m happy for Hony and the other investors, but happier still for Hydoo founders, particularly its chairman, Wang Zaixing, known to friends and family  as “Laowu”, literally “Venerable Fifth”. He is the fifth-born of ten children all of whom played a part in building Hydoo. The family is originally from Chaozhou in Guangdong, and speak the distinctive Chaozhou dialect. But, they ended up after 1949 in Ganzhou, Jiangxi Province.

The business Laowu started 18 years ago is now worth over $1 billion. The first time I met him, I told Laowu my goal as his investment banker, and my emphatic expectation,  was that his company would be worth at least that much at the time of its IPO. Another priority of mine was that he and his family members would still hold majority control after IPO.  That too has been achieved.  They hold almost 60% of the now publicly-traded business.

For me, Laowu personifies in many ways the large economic changes China has undergone in the last 30 years. He started life as a long-distance truck driver and from that humble start saw and grasped an opportunity to build wholesale trading centers for the emerging army of small businesspeople in China.

I first met Laowu and his company in 2009. The business was then called Haode (豪德). It was then still an old-school Chinese family business. There was no corporate structure in the traditional sense. Laowu and his brothers, sister and nephews would pair up, or act independently, to do individual large wholesale trading centers around China. When I met them, the family had already done 19 such projects. All had done very well. At the time, I’d never met a Chinese private company as profitable over as many years as Haode.

Over the last three years, the company has been transformed into a more professional enterprise. Hydoo provides a useful excellent template for how a Chinese family-owned business can make this transition to a publicly-traded company. Part of that process was splitting up the family’s existing business between a group that would follow Laowu and become shareholders of Hydoo, and five other siblings who chose not to participate, but remain active in some cases building their own wholesale trading centers.

As the IPO prospectus puts it,  this division was “a complex, delicate process involving the allocation of assets or interests in the existing businesses among a group of closely connected family members, who decided to split up into two independent groups with diverging goals going forward. Under the special circumstances, no written agreements were entered into in respect of the Family Allocation and no valuation appraised by independent valuers was undertaken when negotiating the Family Allocation. Instead, the Wang Family Group placed their focus on more subjective, personal factors.”

Me and my firm played a small part by advising Laowu and his siblings on the pros and cons of being part of a company planning for an IPO. But, as you’d expect, most of this was done within the private confines of a large, closely-knit family.  Along the way, though, I gained a deeper appreciation of the unique ways Chaozhou people do business.

Chaozhou natives are rightly famous both in China and throughout much of Southeast Asia for their business acumen. They are often described by other Chinese as “the Jews of China”.  As a Jew in China, I tend to think the description flatters my people. Chaozhou people seem to have an instinctive and unsurpassed talent for making money and entrepreneurship. Look around the world at the most successful Chinese business people, including the leading business families in Thailand, Indonesia, Singapore, Malaysia and Hong Kong, and a large percentage, including Asia’s richest magnate, Li Ka-shing, Thailand’s richest businessman Dhanin Chearavanont  and Indonesia’s top tycoon, Mochtar Riady, are either from Chaozhou or are descended from people who immigrated from there.

As this suggests, Chaozhou people are able and willing to uproot themselves and chase opportunities. Laowu didn’t leave China, but in building Hydoo, he did venture far afield from where he and his family were raised. He saw very early and profited richly from an economic shift within China that few others noticed 15 years ago. At the time, much of China’s economic growth was centered in southern China, and large coastal cities like Shanghai, Shenzhen, Xiamen. Laowu looked inland, especially in Shandong Province, one thousand miles north of Chaozhou.

As the economies of Shanghai and big southern coastal cities began to cool, inland areas, led by Shandong, began to boom. Shandong’s GDP growth, over the last ten years, has been among the highest of any part of China. Shandong is a huge market to itself (population 95mn) as well as a vital crossroads for commerce between north and south, east and west in China. Laowu built large wholesale parks to accommodate thousands of small traders, creating new clusters of small-scale commerce and entrepreneurship.

When you visit one of these centers, you get the impression that half of Shandong’s gdp is going in and out the doors. It’s crowded and vibrant. Even the smallest traders own their own small shop inside the Hydoo centers. That’s Hydoo’s model: they build the buildings, and as they do, sell off most of the units to thousands of individual small traders. Hydoo helps them get mortgages and often acts as guarantor on the loans. This lets thousands of small businesspeople become property-owners. As the Hydoo centers thrive (and they all do, as far as I know) the value of the real estate rises.

I know of no other businessman in China that has done as much as Laowu to build wealth and provide an entrepreneurial hub for such a large number of people in China. Hydoo is now spreading across more areas of China. It’s is building huge new wholesale parks in Sichuan, Hunan, Guangxi, Gansu.

I see Laowu infrequently these days. But, I’m as impressed now as I was when I first met him by his accomplishments. He and his family founded a business back when China was a different and less developed place. They stuck with it, kept reinvesting and now, through today’s IPO,  own shares worth more money than I can imagine. But, more important for me is that they still own the business, still own the majority and so answer to no one else. As an entrepreneur who helped create and sustain so many other entrepreneurs, Laowu deserves nothing less.

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Private Sector Capital for China’s SOEs — China First Capital Press Release

Leave a Comment / July 16, 2014

China First Capital press release

Hong Kong, Shenzhen, China:  China First Capital, an international investment bank and advisory firm focused on China, today announces it has received a pioneering mandate from a large Chinese State-Owned Enterprise (“SOE”) holding company to manage a process to revitalize and privatize part of the group by bringing in private capital.

“The investment environment for SOE deals in China is undergoing a significant and exciting change,” commented China First Capital chairman and founder Peter Fuhrman. “We are proud to play a role as investment bankers and advisors in this change, by working with some of China’s SOEs to complete restructuring of unquoted subsidiaries and then raise private sector capital to finance their future expansion. We see these SOE investment deals as the next significant opportunity for institutional investors eager to allocate more capital to China.”

By some estimates, China’s SOEs account for over 60% of total Chinese GDP. Yet, up to now, they have only rarely done private placements or spinoffs to access institutional investment, including from private equity firms. But, according to China First Capital’s internal research, an increasing number of China’s SOEs will face a funding gap in coming years. SOEs, in most cases, have ambitious expansion plans fully supported by the Chinese government. Yet, the SOEs are restricted in their ability to raise large amounts of new bank loans. They are under pressure from Chinese government to maintain or lower their debt-to-equity ratios.

More…

Neue Zurcher Zeitung Interview

 

Better and Worse Investment Ideas For China’s Future

Leave a Comment / October 16, 2013

–tablescreen Where is China headed and how to make money by getting there first? If you were to ask professional China investors, almost without exception you’ll be offered an identical vision of the China of 2020 and beyond:  retired Chinese in their tens of millions living in assisted-living housing spending their days on their smartphones buying clothes, playing games and booking European vacations.

It follows, the pros will tell you, that the best places to put your money today are with Chinese companies building retirement and assisted living housing, mobile apps and online shopping websites. Indeed, these are the sectors getting by far the most attention and seeing the most substantial flows of new investment capital these days.

I happen to think the “smart money” is wrong and here’s why. First, in my experience across 30 years of business life, whenever you get so much agreement about where the future is headed and where money should be staked, the predictions usually prove wrong and the money usually lost.

In this case, the basic analysis is fine. Yes, China is getting older and yes it needs more places to house and care for the elderly. And, yes, Chinese will buy more stuff online since prices are often much lower than in shops. But, only a fraction of the projects now receiving funding will be successes.

The assisted living, online shopping and mobile services businesses already seem over-invested. And yet the money keeps pouring in. It reminds me very much of the last “can’t miss” investment idea in China: group shopping. Two years ago, PE and VC firms poured billions into at least a dozen different group shopping sites in China Most, if not all of that, will be lost.

There are formidable hurdles in the way of all three of the currently-favored business models. For assisted living and retirement housing, it’s not clear Chinese retirees in significant numbers will want to move into these kinds of places, even if their kids are paying. Nor is it clear how these projects will make equity investors money, since Chinese banks remain loathe to lend money to any kind of real estate project.

Online shopping? Great business, but all the companies getting investment have to compete with a few powerhouses with huge market shares. The list includes Alibaba’s Taobao business, Yihaodian (part-owned by Wal-Mart), Amazon China, 360buy.com. I see little reason to believe these newer PE-backed entrants will make any serious dent against these competitors.

As for mobile services, yes Chinese have all switched en masse to smartphones. And, yes, they use the mobiles to do lots of stuff online, including shopping, chat, games. Problem is, in the overwhelming number of cases, Chinese don’t pay for any of it. In my view, they never will. Any investment predicated on the theory that eventually Chinese will start paying fees to mobile service-providers is usually based on not much more than a hope and a prayer. Nothing solid.

So, where else to put money now to be best-positioned for the China of 2020? I can think of two places. One is organic foods and the other is health supplements and what are called “functional foods” in the US.

As of now, both are tiny industries in China, a fraction of their size in the US and Europe. My guess is that the market in China will eventually dwarf those two other places. I’ve read about a few PE investments in these industries. But, in general, the so-called “smart money”  has stayed out.

So, why do I think organic, “functional foods” and supplements will become huge businesses in China? In general, the same forces will prevail in China that have propelled the growth of these industries in the US and Europe: a wealthier population, more interested in their health, more distrustful of traditional commercially-prepared foods, and also more interested to improve their health, fitness and life expectancy by exercising, eating well (including vitamins and supplements) while keeping away from doctors.

In China, this distrust of commercial foods and commitment to a more healthful lifestyle, though still in a comparatively early stage,  is already strong, deep and widespread. So is the lack of trust in the quality of medical care received from doctors.

As anyone who lives in China can attest, there are very good reasons for all of this. Food scandals are common. There seems to be a lot of unhealthy and unhygienic food circulating.  Doctors don’t enjoy a very high standing any longer. They are often seen as fee-grubbing predators, ever willing to make phony diagnoses as a way to put more money in their pockets from their share of fees paid for tests, medicines, surgery, hospital care.

In short, the conditions couldn’t be riper for the development of organic foods, and health supplements of all kinds. Chinese traditional medicine shares quite a few principles in common with the OTC health supplements sold in the US. Chinese, in a way Westerners generally do not, have always accepted that Western pharmaceuticals should often be taken as a last resort. They worry greatly about side effects. If there’s a more “holistic” way to treat a condition, Chinese will often prefer it.

China, as of today, has no vitamin and supplement shops like GNC in the US, nor do mainstream pharmacies give such products any shelf space. When you can find them, vitamins are sold at very high prices in China, usually at least double the US level. There are no good domestic brands, no winning products or packaging formulated specifically for Chinese consumers.

One data point: it’s more and more widely known in China that fish oil is beneficial for digestion and circulation. And yet, it’s hard to find the product anywhere in China. When you do, it is usually stuff imported from the US, in old-looking packaging, with English-language  labels, and prices three to four times higher than in America.

Whether the world has enough cod livers to meet future Chinese demand for fish oil is another story. But, I’m confident the China market should eventually rival the US’s in size.

As for organic and healthy foods, China has lots of conventional supermarkets. But, so far no one has tried to follow the path blazed by Whole Foods Market in the US. Nor are there large, established organic food brands like Organic Valley, Applegate.

It will all happen. When, and which investors will make the big money is hard to say. Even now, the demand for genuine organic fruits, vegetables and dairy outstrips the available supply. There’s yet no real standard in China for what can be called organic, and so Chinese consumers often view products labeled that way with suspicion. That too represents a business opportunity in China — providing standards and credentials for the organic farming industry.

The lesson here: in China, the best business opportunities are often hiding in plain sight, often unseen by professional investors. Nowhere is contrarian investing more warranted and more potentially profitable.

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Mongolia: Investment Banking Adventure on the Grasslands

Leave a Comment / October 9, 2013

 

Mongolian grasslands–

Investment banking isn’t meant to be particularly fun.  There’s too much pressure, too much market uncertainty, too much money on the line. You toil in a big urban office tower, dressed in a suit and tie, and spend sixteen hours a day moving commas around in an Excel spreadsheet.

This may be true for some, or even most, investment bankers. But, it is decidedly not the case for me. My working life is a delight. Occasionally, it’s better than a boyhood dream of adventure and discovery.

Take this recent workday: out the door and on the road by 6am to beat the traffic. In 15 minutes, we’ve left the city behind and cruise south on a two-lane highway. The sun is rising over stubby hills, more like scattered lumps of clay.  Gradually the land flattens, narrow valleys open into broad vistas of low willowy bush turned a golden autumn color.

I’m in Mongolia, and we’re driving straight across the grassland. For two hours, we drive down a straight paved road, hugging close to the single track railroad line that connects Mongolia’s capital Ulan Bator with Beijing to the south and Moscow to the distant northwest.

The train from Beijing chugs by at around 9am, moving slowly, at around 30mph (50kph). I took the train once more than thirty years ago. It’s a six-day trip from Beijing to Moscow. From this brief glimpse, nothing much has changed. Same green-colored carriages, dual diesel locomotives and a restaurant car. I remember eating well the first day, when the train was still in China. After that, the kitchen crews changed and little or nothing edible came from the restaurant car kitchen. I ate mainly Chinese preserved duck eggs (皮蛋）and small snacks bought on the platform as the train crossed Siberia.

Today I’m in a comfortable new Lexus four-wheel drive jeep. We stay on the paved road for 120 miles (200km) and then turn left onto a dirt road. It’s really just a narrow path worn in the grass. We pass a small abandoned Soviet era air base, presumably once meant to be a secret facility 250 miles from the Chinese border. All that remains are 30 fortified hangars, a crumbly old runway and miles of barbed wire fencing.

We take this dirt road southeast another 100 miles or so and then pull into the iron ore mine I’ve come to visit. The whole way along the dirt road we pass nearby huge herds of grazing animals  — sheep, cashmere goats, Mongolian horses and cows. We see few vehicles along the road. Every ten miles or so, set back about one mile from the dirt path, we pass a small grouping of white Mongolian yurts.

I ask the driver to stop at one, so I can have a closer look and meet the nomads. The driver is Chinese, but was born and raised in Mongolia. He translates. We get a very warm welcome from the three people living in the two yurts, one of which has a solar panel. It’s an older man together with his son and daughter-in-law. This is their summer encampment. They have hundreds of sheep, horses, cows roaming around.

Mongolian yurt

The wife urges me to help myself from a bowl of, well, I don’t know what. It’s a small heap of brownish solid irregularly-shaped tubes of different lengths. Something home-made. I prepare myself for something sour and strange. Instead, it’s sweet and chewy, a preserved candy made from yogurt.

Next, the men pour me three cups of their home-brewed alcohol, a slightly-sweet not very alcoholic drink distilled from cow milk. The flavor is crisp and dry, like a slightly-corked chablis.  By the time I’m back in the car, the younger man is atop a horse and riding quickly off towards a distant ridge.

I first learned about the iron-ore mine from its owners, a Chinese SOE, about four months ago. They bought the mining rights four years ago, built the mine, hired the local workers and began producing high-grade iron ore two years ago. It’s an open-cast mine working a particularly high-grade seam of iron ore. The rock is over 30% pure iron.

As mining operations go, they hardly get any simpler. Caterpillar backhoes scoop up rock, which is then put on a conveyor belt for a simple mechanical sorting operation. This doubles the grade of ore. From here, the ore is trucked seven miles to a railroad platform the company built. It is loaded on to open freight cars and sent by rail directly to supply a large steel mill in China’s Hebei province. Even though the iron ore price has fallen over the last several years, the Mongolian mine makes very good money. It is probably the lowest-cost and highest-quality ore supplier in or around China, the world’s biggest market for iron ore. They dig money out of the ground.

Iron ore Mongolia

The owners were eager for me to visit. They want to retain China First Capital to act as their investment bankers. They are considering a possible sale. While the mine is making very good money, with almost 40% net margins, the SOE is considering a sale for two reasons. The parent company is huge, one of China’s largest mining businesses. Their main business is coal mining. This is their only iron ore mine and only project in Mongolia.

Chinese companies were among the first to secure mining rights in Mongolia after that country’s 1990 democratic revolution. But, over time, Mongolian policy has gradually shifted. Chinese companies are less welcome. The Mongolians have grown more and more anxious that their tiny economy will become too dominated by China. (Mongolian gdp is $15bn, or less than 0.2% China’s $8 trillion.) They know their abundant low-cost mineral resources — coal, copper, iron ore — will almost all end up being sold to China. But, they seem to prefer when the mines are owned by companies from elsewhere. North America, Europe, Russia are all preferred.

In the two years since it began operating, the mine has made excellent progress. It should keep producing for another 30-50 years. Its stated reserves are probably less than one-fifth of the actual total. It’s all surface-mineable, all high-grade. There are bottlenecks. The company would like to increase the number of loaded train cars it sends south to China. But, it’s so far been a hassle to negotiate with the Mongolian state railroads. A non-Chinese owner would likely have more luck. Also, the equipment is not winterized, so they produce and ship ore only about six months a year.

After a lunch of boiled Mongolian beef bones (tastes much better than it sounds), we begin the drive back, stopping first to visit the rail platform. After that, I jump out of the car once, to climb a small hill topped by a pillar of small stones one-meter high. It’s a simple Tibetan Buddhist stupa. Everywhere, in every direction, the scenery is breath-taking in its simplicity and grandeur.

Mongolian stupa

I’ve only once before made a car trip across such a large expanse of largely-unpopulated and rarely-visited land.  That was 24 years ago, back when I was working as a foreign correspondent for Forbes. I was in Namibia, and drove the 200 mile length of the fenced-in diamond mining concession jointly owned and operated by De Beers.

In general, no one except De Beers senior staff is allowed to enter this huge 10,000 square mile pristine piece of Africa. That day I recall seeing a few ostriches running across the sandy desert. The De Beers team mentioned seeing packs of wild elephant.

This day, on the Mongolian grasslands, animals are plentiful. All are fattened by a summer of plentiful grazing, and look remarkably healthy.

The nomads these days are selling fewer and fewer of their herds. They sell just enough to supply the demand in Ulan Bator, a city of about 1 million. So, their herds grow larger every year by about a net 20%. They have more meat on-the-hoof and more milk than their ancestors could dream of. It’s never been a better time to be a yurt-dwelling Mongolian herder.

But, their lives are still tough, especially during the long winter, when they huddle together in their yurts, with their animals sheltered nearby. Temperatures can reach minus 40 centigrade. More and more Mongolians are leaving the grasslands and migrating to take salaried jobs in Ulan Bator. That city has more than doubled in size in the last 20 years.

I spend a few hours of my free time back in Ulan Bator visiting the city’s largest Tibetan Buddhist monastery and the Zanabazar Museum, which has the most remarkable collection of 19th century Tibetan thangkas, painted and applique, I’ve seen anywhere. To my knowledge, there’s nothing comparable left in Tibet or elsewhere in China.

Mongolian thangka

I’m fortunate to own a small collection of antique thangkas. I’d been waiting twenty years to visit the Zanabazar Museum.

I should have a chance to come back to Mongolia next year, once the frigid winter passes. Maybe this next trip I’ll be bringing along some potential buyers for the mine. I’m doing exactly the kind of work I most enjoy, for clients that are a pleasure to work with. Every place I travel for work I’m welcomed with the greatest degree of hospitality, fed and housed royally.

Two other positives of my job: I need to open Excel only occasionally, and I almost never have to wear a jacket and tie.

 

 

The China IPO Embargo: How and When IPOs May Resume

Leave a Comment / September 26, 2013

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China IPO

China first slowed its IPO machinery beginning July 2012 and then shut it down altogether almost a year ago. Since then, about the only thing stirring in China’s IPO markets have been the false hopes of various analysts, outside policy experts, stockbrokers, PE bosses, even the world’s most powerful investment bank.  All began predicting as early as January 2013 the imminent resumption of IPOs.

So here we are approaching the end of September 2013 with still no sign of when IPOs will resume in China. What exactly is going on here? Those claiming to know the full answer are mainly “talking through their hat“. Indeed, the most commonly voiced explanation for why IPOs were stopped — that IPOs would resume when China’s stock markets perked up again, after two years of steady decline — looks to be discredited. The ChiNext board, where most of China’s private companies are hoping to IPO, has not only recovered from a slump but hit new all-time highs this summer.

Let me share where I think the IPO process in China is headed, what this sudden, unexplained prolonged stoppage in IPOs has taught us, and when IPOs will resume.

First, the prime causal agent for the block in IPOs was the discovery in late June last year of a massive fraud inside a Chinese company called Guangdong Xindadi Biotechnology.  (Read about it here and here.)

This one bad apple did likely poison the whole IPO process in China, along with the hopes of the then-800 companies on the CSRC waiting list. They all had underwriters in place, audits and other regulatory filings completed and were waiting for the paperwork to be approved and then sell shares on the Shenzhen or Shanghai stock exchanges. That was a prize well worth queuing up for. China’s stock markets were then offering companies some of the world’s highest IPO valuations.

After Xindadi’s phony financials were revealed and its IPO pulled, the IPO approval process was rather swiftly shut down. Since then, the CSRC has gone into internal fix-it mode. This is China, so there are no leaks and no press statements about what exactly is taking place inside the CSRC and what substantive changes are being considered. We do know heads rolled. Xindadi’s accountants and lawyers have been sanctioned and are probably on their way to jail, if they aren’t there already A new CSRC boss was brought in, new procedures to detect and new penalties to discourage false accounting were introduced.  The waiting list was purged of about one-third of the 800 applicants. No new IPO applications have been accepted for over a year.

IPOs will only resume when there is more confidence, not only within the CSRC but among officials higher up, that the next Xindadi will be detected, and China’s capital markets can keep out the likes of Longtop Financial and China MediaExpress, two Chinese companies once quoted on NASDAQ exchange. They, along with others, pumped up their results through false accounting, then failed spectacularly.  Overall, according to McKinsey, investors in U.S.-listed Chinese companies lost 72% of their investment in the last two years.

China’s leadership urgently does not want anything similar to occur in China. That much is certain. How to achieve this goal is less obvious, and also the reason China’s capital market remains, for now, IPO-less.

If there were a foolproof bureaucratic or regulatory way for the CSRC to detect all fraudulent accounting inside Chinese companies waiting to IPO in China,  the CSRC would have found it by now. They haven’t because there isn’t. So, when IPOs resume, we can expect the companies chosen to have undergone the most forensic examination practiced anywhere. The method will probably most approximate the double-blind testing used by the FDA to confirm the efficacy of new medicines.

Different teams, both inside the CSRC and outside, will separately pour over the financials. Warnings will be issued very loudly. Anyone found to be book-cooking, or lets phony numbers get past him,  is going to be dealt with harshly. China, unlike the US, does not have “country club prisons” for white collar felons.

The CSRC process will turn several large industries in China into IPO dead zones, with few if any companies being allowed to go public. The suspect industries will include retail chains, restaurants and catering, logistics, agricultural products and food processing. Any company that uses franchisees to sell or distribute its products will also find it difficult, if not impossible, to IPO in China. In all these cases, transactions are done using cash or informal credit, without proper receipts. That fact alone will be enough to disqualify a company from going public in China.

Pity the many PE firms that earlier invested in companies like this and have yet to exit. They may as well write down to zero the value of these investments.

Which companies will be able to IPO when the markets re-open? First preference will be for SOEs, or businesses that are part-owned by or do most of their business with SOEs. This isn’t really because of some broader policy preference to favor the state sector over private enterprise. It’s simply because SOEs, unlike private companies, are audited annually, and are long accustomed to paper-trailing everything they do. In the CSRC’s new “belt and suspenders” world, it’s mainly only SOEs that look adequately buckled up.

Among private companies, likely favorites will include high-technology companies (software, computer services, biotech), since they tend to have fewer customers (and so are easier to audit) and higher margins than businesses in more traditional industries. High margins matter not only, or even mainly, because they demonstrate competitive advantage. Instead, high margins create more of a profit cushion in case something goes wrong at a business, or some accounting issue is later uncovered.

The CSRC previously played a big part in fixing the IPO share price for each company going public. My guess is, the CSRC is going to pull back and let market forces do most of the work. This isn’t because there’s a new-found faith in the invisible hand. Simply, the problem is the CSRC’s workload is already too burdensome. Another old CSRC policy likely to be scrapped: tight control on the timing of all IPOs, so that on average, one company was allowed to IPO each working day. The IPO backlog is just too long.

The spigot likely will be opened a bit. If so, IPO valuations will likely continue to fall. From a peak in 2009, valuations on a p/e basis had already more than halved to around 35 when the CSRC shut down all IPOs.  IPO valuations in China will stay higher than, for example, those in Hong Kong. But, the gap will likely go on narrowing.

What else can we expect to see once IPOs resume? Less securitized local government borrowing. Over the last 16 months, with lucrative IPO underwriting in hibernation,  China’s investment banks, brokerage houses and securities lawyers all kept busy by helping local government issue bonds. It’s a low margin business, and one not universally approved-of by China’s central government.

How about things that will not change from the way things were until 16 months ago? The CSRC will continue to forbid companies, and their brokers, from doing pre-IPO publicity or otherwise trying to hype the shares before they trade. If first day prices go up or down by what CSRC determines is “too much”, say by over 15%, expect the CSRC to signal its displeasure by punishing the brokerage houses managing the deals.  The CSRC is the lord and master of China’s IPO markets, but a nervous one, stricken by self-doubt.

China needs IPOs because its companies need low-cost sources of growth capital. When IPOs stopped, so too did most private equity investment in China. It’s clear to me this collapse in equity funding has had a negative impact on overall GDP, and Chinese policy-makers’ plans to rebalance its economy away from the state-owned sector. It’s a credit to China’s overall economic dynamism, and the resourcefulness of its entrepreneurs,  that economic growth has held up so well this past 18 months.

IPOs in China are a creature of China’s administrative state. Companies, investors, bankers, are all mainly just bystanders. Right now, the heaviest chop to lift in China’s bureaucracy may be the one to stamp the resumption of IPOs. So, when exactly will IPOs resume? Sometime around Thanksgiving (November 24, 2013) would be my guess.

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Investors Vs. Asset Managers: A Dysfunction at the Heart of China Private Equity

1 Comment / September 12, 2013

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Assuming the same level of risk, would you rather make $100 from investing $10 or from investing $50? Easy, right? Who wouldn’t choose to make ten times your money, rather than just double it? There is one group I know. Private equity firms active in China. At least some of them. They care more about the amount they can invest in a deal than the profits they stand to make.

The illogic at work here is the direct result of some particular, not very appealing characteristics,  of the PE industry in China. PE firms lately have more confidence in their ability to raise money than to invest it profitably by achieving a timely exit. To raise money, though, a PE firm needs first to spend most of what it already has. Result: a rush to get money out the door and parked in deals.

In industry parlance, “check size” is often more important than potential risk-adjusted returns.This is one reason for the recent rash of “take private” PtP deals of Chinese companies quoted in the US. (See previous articles, including here, here, here. ) The transactions seem to me ill-considered. PEs have invested billions of dollars in such deals but there is not a single successful example they can point to of such PtP deals done in the US making money for investors. This must be a PE industry first — so much LP money put at risk against an investment idea that is totally unproved.

Who’s most harmed from focus on “check size” over deal quality and prospective returns? Of course it’s the LPs whose money is put into these deals. They want and need high returns, not bigger deals done using their money to aid PE firms’ future fund-raising.

But, Chinese entrepreneurs also suffer in this environment, because many PE firms now simply won’t look at deals where they can’t invest at least $25mn for around 25% of the company. There are few deals out there in that size range, meaning deserving entrepreneurs can’t find investors.

The big picture here: PE in China has become more and more a business dominated by asset managers not investors. How to tell the two apart? An asset manager enjoys the comfort and certainty of making a steady 2% a year managing other people’s money. The more money they raise, the more money they keep. Good markets or bad, the money keeps rolling in.

An investor, on the other hand, is a whole different animal. They share some DNA with the entrepreneurs they back. They love the sport of finding and evaluating deals, spotting where big money can be made, putting money at risk. When it works, they make big sums for their investors, and keep a nice chunk themselves.

Needless to say, LPs give money to PE firms in hopes they have chosen investors not asset managers. PE firms know this, of course, and tailor their money-raising pitch accordingly. They stress their deal-making prowess, not the fact that over the life of a typical 10-year fund, an LP will start with a 20% cumulative loss, because of the typical annual management fee deductions.

In China, it used to be fairly easy to make money in PE. But, over the last three years, returns began to head south. More recently,  over the last 18 months, the performance has mainly been dismal, with few successful deals exiting with big profits. It’s getting harder and harder for LPs to make money in China PE, after those accumulated management fees have been deducted.

But, there’s a time lag — as well as an information asymmetry — at work here. While recent performance has been, on the whole, lousy, there’s still appetite among LPs to allocate more money to China. A big reason is that China’s economy, and capital markets, are both the second-biggest in the world. Most LPs are seriously underweight China and want to change that.

And so we arrive at the current paradoxical situation, where it’s still comparatively easier to collect money to invest in China than to make money deploying it. Now, of course, PE firms can only succeed in raising capital if they can point to some successful past deals. Here too there’s an information asymmetry at work. Many PE firms did well from 2005-2010, and so their fund-raising documents emphasize deals done during this era. But, the game has changed out of all recognition since then.

Few, if any, PE firms have shown they can continue to earn investors good money when markets become less accommodating. It’s no longer possible to play the game of valuation arbitrage, of investing in China deals at single digit p/e multiples, and exiting them soon after at 5-10 times higher multiples through an IPO.

Earning a profit on an investment takes preparation, luck and time. Making money by convincing people to pay you a fee to manage theirs, by contrast, is a much simpler proposition, as well as a no-lose one.

And so the gulf widens between the objectives of PE firms and the fiduciary responsibilities and performance goals of the institutions whose money they manage.

This can be a problem everywhere in the PE and VC industry, as well as more broadly wherever people get paid to manage assets owned by someone else. (See principal-agent dilemma.)   But, it’s probably especially pernicious in China PE.

The industry is staffed mainly be ex-investment bankers, who by background and temperament understand more about fee-based, than performance-based, compensation. Few have a background of actually managing a company, investing its capital to produce a return. Without this first-hand understanding, it’s far harder as an investor to plot how to make an operating business more valuable. The result: PE firms in China will often opt for an easier path: making money by raising money from, and managing for,  other financial professionals.

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China SOEs — How They Think and Why

Leave a Comment / December 15, 2013

– China First Capital blog There are many flavors of State-Owned Enterprise (“SOE”)  in China, from polluting monster chemical factories to quaint dumpling houses that date from before the revolution.  Since coming to China, I’ve seen up-close quite a number SOEs, probably more than most other non-Chinese. No two are quite alike. But, equally, SOEs in China, from the largest centrally-administered “national champions” (known as 央企, or “yangqi”, in Chinese and include such familiar names like Sinopec, China Mobile, ICBC) that earn billions in profits every year to smaller local loss-making industrial companies with a few hundred employees, share a similar genetic code. Or more precisely, provide the same iron rice bowl.

That phrase (铁饭碗 ) was widely used during Mao’s time, and I still heard it frequently when I first came to China 1981.  It’s since faded from common use. But, the concept remains embodied within all SOEs. Simply put, an “iron rice bowl” means a job for life, and so a life without the worry of going unfed. In today’s China, with the threat and the memory of famine now extinguished, it’s more a way of expressing the unique way an SOE functions, how it views its role in society and the benevolent — some might say paternalistic — way it cares for its employees.

An SOE is, above all,  a very Chinese institution, and in many ways, one of the few holdovers from the Maoist era.  Chinese then didn’t so much work for a company as they belonged to a “work unit“, a 单位 (“danwei”). A paying job was in some senses the least important thing provided by one’s work unit, since cash salaries used to be very low, under $10 a month for mid-level managers. Instead, one’s work unit provided housing, schools, communal heating, medical care, ration tickets, permission to marry, to travel or have a child, subsidized meals and fresh food.

In theory, the work unit was the Great Provider, anticipating and meeting all of one’s needs in life. In practice, of course, it offered not a lot more than a very rudimentary existence and a job for life. For most Chinese, especially all working for private sector companies, the danwei system was dismantled ten years ago. A job is just a job, not a lifetime meal ticket.

But, for those working at SOEs, many of the more desirable features of the danwei system have been preserved, starting with the fact you are very unlikely ever to be fired. What’s more, the company itself is also highly unlikely to ever go bankrupt or face a serious crisis that would lead to mass layoffs.  Today’s SOEs hold, in effect, a permanent right to operate, regardless of market conditions.

China’s current group of SOEs are a privileged rump, those spared from a massive cull over ten years ago. That put the worst, least efficient SOEs out of business, and forced tens of millions to take early retirement or go off in search of new jobs, mainly in the private sector.

SOEs, along with the military and the Party, are the third of China’s key pillars of state power. While each is subject to the control of the country’s leadership, each also operates, to some extent,  by rules of its own. Chinese leaders are known to complain, at times, about the power, wealth and influence of the country’s larger SOEs.

SOEs are ultimately kept in business by other SOEs — loans from the state-owned banks, and orders or supplies from fellow SOEs. In most cases, they have a marked preference for doing business with one another.  Partly, this is because SOEs tend to understand better the way other SOEs think and act. Partly, it’s also because SOEs function together as mutual assistance society. If one gets in trouble, others will either voluntarily help out, or be ordered to do so by SASAC （“国资委”）, the government organization that manages Chinese SOEs.

SOE jobs usually pay less than private sector competitors. But, for many, that’s more than compensated by the perks that come with the job. While Google is famous for its free food and recreation areas,  an SOE has its own attractions, tailored to the tastes of its Chinese employees. Workloads tend to be modest, and a long lunchtime siesta is built into every working day. During winter, the company will often provide extra cash to pay for heating.

There is, in my experience, an obvious camaraderie among SOE workers,  a shared identity and pride working for what are usually very large, well-known companies that tower over their private sector competitors and neighbors. If not always in practice, at least in theory, an SOE is meant to be in business for the benefit of all of China, not to accumulate profits or generate wealth purely for its shareholders.

It’s a noble mission, but one that can lead to its own rather systematic form of inefficiency. Urged on by SASAC, they set ambitious growth targets every year to increase output. They achieve this, in most cases, by pouring more borrowed money into new capital equipment, often to produce products the government says China needs or wants. The amounts invested, and the returns on those investments, tend to move in opposite directions.

SOEs can borrow at half the cost of private sector companies. Their hurdle rate is also often half that, or less, than private companies’.  As a result, projects with limited financial rationale often get built.

Take LEDs, solar and wind power. All three were heavily over-invested by SOEs because the Chinese government had made such “green energy” projects a national priority. More energy was probably consumed forging the steel and building factories and equipment to produce LED assemblies, solar panels and wind turbines than has been saved by lowering overall energy use in China. A lot of these LED, solar and wind projects are now mothballed, due to losses and falling demand.

Part of what SOEs exist to do is to take government economic policy and turn it into hard, if sometimes not very productive, assets. That outlook, of course, also impacts the way SOE staff work. Their pay isn’t linked to profits any more than company-wide strategy is.

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

2 Comments / March 11, 2014

—CLP

 

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

What is China First Capital?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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China SOE Accounting — BAAP Not GAAP Applies

Leave a Comment / December 15, 2013

China SOE accounting–

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If the last two years of crisis in investing in Chinese companies proves anything, it’s that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones,  if professional short-sellers like Muddy Waters, as well as securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones,  live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise (“SOE”). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside,  is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That’s because SOEs also operate by their own set of accounting standards. I call it “Chinese BAAP“, or “bureaucratically accepted accounting principles“. This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC’s job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management’s weekend gambling junket to Macao. This isn’t to say that such things can’t occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I’ve personally spent during 2013 studying and complying with SOE payment procedures, I’d probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn’t impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company’s expenses and revenues. It’s also to make sure all of last year’s assets, plus any new ones bought during the current audit year,  can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to,  an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn’t know how to perpetrate accounting fraud if they were being paid to do so. They’ve grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on,  would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.

 

China SOE Buyouts — Case Study Part 2

Leave a Comment / December 15, 2013

Jin finial

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When you can find them, State-Owned Enterprise (“SEO”)  buyouts are among the better investments in China. The reasons: the companies are cheap, professionally-managed and free of accounting fraud. The not-trivial challenge: finding good SOEs that can be bought.

For such an important part of the world’s second-largest economy, Chinese SOEs are widely misunderstood. They account for at least 20% of China’s GPD. Some estimates put SOEs’ contribution to GPD at 60% or higher. But, SOEs are often characterized, to quote from a World Bank analysis, as “dying dinosaurs that continuously absorb resources from the economy but produce little economic value.”

To be sure, there are many SOEs that fit this description. But, equally, there are plenty of good businesses among China’s more than 150,000 SOEs. The good ones, quite often, can be made substantially better by bringing in outside capital and chopping away at the heavy bureaucratic crust.

Buyouts make money when a new owner buys an business for less than it’s worth, then reinvigorates it. Generally that’s done by buying lazily-run subsidiaries inside larger conglomerates.

No conglomerate anywhere, at any time,  has been more laid-back about managing its assets than SASAC, the huge government organization that is the legal owner of most Chinese SOEs.

SOEs operate in, but are not entirely of, the market economy. They benefit from cheap and plentiful capital via loans from state-owned banks. But, SASAC is generally far more concerned with increasing revenues and investment than profits. SASAC generally doesn’t demand SOEs pay it dividends. Instead, it asks for an audit every year that shows an SOE’s revenues and assets are growing, and no money is actually being lost or assets pilfered. SASAC doesn’t act like an owner so much as a custodian.

SASAC’s casual attitude to profit-making filters down to all levels within an SOE.  Given the choice to maximize or minimize profits, most SOEs will choose the latter.  The goal is to make a little more than last year, but not so much that SASAC, or more senior levels in government, begin to ask questions. With few exceptions (mainly larger centrally-administered SOEs quoted in the US like China Mobile and PetroChina) the corporate equivalent of a “gentleman’s C“, a net margin of around 2.5%, is considered satisfactory.

You don’t need to be a Buffett, Bonderman, Kravis, or Rubenstein to make money buying the right Chinese SOE. You generally don’t need to get your hands too dirty, launch a hostile takeover, borrow a ton of money, or make yourself unpopular by firing surplus workers. It’s going to be enough in most cases just to retain and incentivize current managers, and inform them that their goal now is to deliver net margins as good as, if not better, than private sector competitors.

Not in all cases but many, the current management of an SOE is quite good, professional, dedicated. The managers operate within a system that downplays the importance of maximizing profit. So, they behave correspondingly. But, that doesn’t mean they don’t know how to do so, especially when they have their salary or share options tied to profitability.

In a previous post I mentioned our two new SOE clients. We are working now to privatize them by selling majority ownership to a private sector investor. Both are 100%-owned by one state-owned holding company which, in turn, is fully-owned by another, even larger SOE holding group. Above them, is the local SASAC in the city where the holding companies are both headquartered. No sooner did we start asking the managers how to improve profits, then they began to share information on how much additional profit was being left unclaimed — unnecessary commission payments, tax rebates not filed for, revenues booked through unrelated group companies.

In the case of these two companies, the current CEOs have been running the businesses since they were started more than five years ago. They are about as far from a stereotyped paper-pushing “SOE Manager” as one could imagine. They are in their mid-40s, and take evident pride in running their businesses as efficiently as any Western manager would. The difference is, a lot of the profit they earn is siphoned off through lots of internal layers within the holding group. At the moment, that’s of little concern to them. They are ordinary salaried workers giving SASAC precisely what it wants. Giving more would do nothing to advance their careers, or fatten their pay packets.

These two CEOs are excited and ambitious to run independent private sector companies that will be free to make and keep as much money as the market and tax laws allow. I have confidence that in both cases, net income would more than double within two years, and triple within five.

What’s needed isn’t restructuring. It’s gardening. You weed out all the unnecessary fees, commissions and chop back the overheads. This reveals the companies’ genuine – and impressive – bottom line.

We are still doing our internal work with the companies, but will soon start the search for new majority owners for each company. All the layers above, up to and including the local SASAC, seem to support these transactions. Why? The holding company already has one very successful publicly-traded company. Once spun off, these two subsidiaries should follow a similar path and one day go public. That is the surest way to assure the companies have sufficient access to low-cost capital and so finance continued growth. Both companies, with revenues of over $100mn, are growing quickly.

Everyone is currently in agreement that the best way for these two subsidiaries to become not just the largest but the most profitable companies in their industry in China is by bringing in majority private shareholders, both to invest in the business and provide more focused, profit-oriented ownership. They sought our investment banking and advisory help to do so.

This isn’t to say these deals, or any SOE takeover, is as effortless as body-surfing. The privatization process in China is still evolving. Any transaction like this will likely generate some opposition. From whom? And from what level? Both are impossible to say.

A separate concern of mine: there are far too few capable and experience takeover firms active in China. Among those that are around, the level of experience and comfort with buying control of an SOE is not uniformly high. Done right, the new owners would be able to profit from a large gap between the current asset value as calculated using SASAC rules and each company’s level of underlying and future profitability. In other words, you buy using NAV but sell later on a p/e multiple.

Making money on that swap, from NAV-to-p/e, is the simple idea at the heart of many of the world’s most successful takeovers. Opportunities to do this are now quite rare in the US and Europe, which is one reason the returns for big buyout firms like KKR, Blackstone and Carlyle has generally been trending down over the last 25 years, and why it’s harder for Warren Buffett to find the kind of underpriced gems he treasures most.

The best days of takeovers have passed, right? Or should Buffett, Rubenstein, Bonderman and Kravis be booking flights to China?

 

 

Preying on China’s distress — IFR Asia

Leave a Comment / June 24, 2016

–IFR

Preying on China’s distress

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IFR Asia 806 – July 27, 2013 | By Timothy Sifert

Global advisory firms are beginning to allocate more resources to China in a bet that slowing economic growth and tighter credit conditions will lead to a rise in restructuring opportunities.

Slowing growth and mounting debt burdens are creating an environment that is, in theory, ripe for turnaround specialists and distressed debt investors. A number have been adding senior staff in China, a market that remains largely untapped relative to the rest of Asia.

Investors, however, warn that restructuring specialists may find doing business in China a lot more difficult than they anticipated.

AlixPartners has doubled the size of its team in Asia to about 70 in the last two years. Alvarez & Marsal appointed Yansong Xue and Bing Liu as directors in Beijing this month. Both firms plan to continue expanding in China and elsewhere in Asia.

“Most of our work is done when you have a leveraged Chinese company with some kind of private-equity firm backing it and it’s in default,” said Ivo Naumann, managing director, AlixPartners, Shanghai. “We are engaged by equity owners and creditors to help with leadership in the process, and are often brought in as an interim manager.”

Turnaround shops, however, are also targeting the underperforming China operations of multinational corporations.

“For many Western companies, five or 10 years ago, you just had to be in China irrespective of profitability, and that was fine when you were making a lot of money in Europe and the US, but it’s not working now,” Naumann said.

Chinese growth has slowed in nine of the past 10 quarters, and data last week showed that the country’s production lost momentum for the third straight month.

At the same time, companies are facing a tougher time accessing financing as regulators force banks to reform their risk management and rein in off-balance-sheet lending. A liquidity squeeze in China’s money markets has pushed up the cost of bonds, and no domestic IPO has priced since October 2012.

Refinancing pressures in China have rarely led to the kind of restructuring or turnaround opportunities that are common in the US and Europe. No domestic bond issue has defaulted, while local politics and laws related to restructuring have often frustrated international investors, adding to general linguistic and cultural differences.

Advisers, however, believe the renewed focus on reform under Premier Li Keqiang will lead to more opportunities for conventional workouts.

Predator and saviour

Many on China’s long list of PE-backed companies are already feeling the pressure, they say.

Over the past decade, the market for Chinese PE has grown rapidly, only to decrease just as rapidly as the local PE markets offered few exit opportunities. PE investments in China are on pace to reach US$6.4bn for the full year 2013 – that is a 64.2% decline from the 2011 peak. (See Chart.)

This ebb in new investments means fund managers are spending more time on existing portfolios.

“[R]unning a private equity fund has become much more of a value-add business in that funds now have to manage their portfolio companies,” said Oliver Stratton, co-head of Alvarez & Marsal Asia, a turnaround firm. “They’re not only investors, and they can’t be passive. So, they’re thinking, ‘we actually have to grow earnings now and fix up the balance sheet’.”

What is more, foreign firms have not always committed the necessary local resources – or had the patience – to address the full scope of the market. The effect is a missed business opportunity.

“Broadly speaking, there is an almost-unimaginably huge money-making opportunity available for turnaround/restructuring firms to act as predator and saviour for PE portfolios in China,” said Peter Fuhrman, chairman and CEO of China First Capital, an international investment bank focusing on China.

“But – and it’s a very big but – there really are few if any firms with that capability, experience, focus. It is, therefore, a great example of why often the best and easiest opportunities to make money in China are overlooked or not acted upon.”

Meanwhile, in part because China’s bank loan market is opaque, potential investors have had to go to greater lengths to get basic information on local assets. On a few occasions, investors have called on risk consultancies to vet PRC loans and the parties backing them.

“We don’t help clients source investments, but we see growing demand to investigate non-performing loans in China,” said Tadashi Kageyama, senior managing director at Kroll Advisory Solutions in Hong Kong. “Interest in these assets should grow after the liquidity squeeze this year.”

Out of court

The Chinese court system, and the way it deals with bankruptcy, can be both a benefit and a hurdle to restructurings. Turnaround specialists said that judges were often quick to liquidate a defaulted firm, rather than engage in a lengthier workout process that could have benefits for debtors and creditors.

“China has a modern bankruptcy code that’s fine and as good as in Europe,” said AlixPartners’ Naumann. “It’s just that the courts and creditors have limited experience in executing it. Their intentions are good, but, in mainland China, a judge’s performance is often measured by the number of cases decided. So, for a judge to engage in a lengthy and highly complex turnaround process, it is challenging. This may sometimes lead to a situation where a liquidation is given priority over a turnaround process.”

As a result, sources said, PE-backed companies – their managers, debtors and creditors – often wanted to settle things out of court. That is where restructuring firms can come in to turn things around.

Yet, to be a relative success in this market is probably going to take a bigger commitment than firms have demonstrated in the recent past. Not a lot of money has been made in China restructuring relative to the rest of the world, sources say.

“It is not particularly difficult for foreign or domestic firms to make money in China, but why no turnaround firms? It starts from simple, humble, unsexy things like none of these guys have real offices in China with significant Chinese-speaking teams with experience in fixing what’s broken inside a Chinese company,” CFC’s Fuhrman said. “They will quickly gravitate to better-paying jobs in PE or investment banking.

“Without teams, you can’t do squat.”

 

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China Investment Banking Case Study: An SOE Privatization

4 Comments / December 15, 2013


China First Capital Signing ceremony

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Anyone who’s dipped into this blog will know that I rarely, if ever, discuss directly what me and my company China First Capital do, our client work. Partly it’s because the work is usually by necessity confidential (clients, investors, deal terms) and partly because I don’t blog as a marketing tool.

But, I plan over coming months to share significant details about a “live deal” we are now working on, a buyout transaction involving a Chinese state-owned enterprise (SOE). The reasons: its size and structure make it an unusual transaction in China, and one that might also bust some myths about the way business in China, especially involving SOEs, actually works.

While I can’t reveal the name of the company, I can disclose why I think it’s such a compelling deal.  Our client is one of China’s largest, most well-known and most successful SOEs. The group’s overall annual profit of over Rmb12 bn (about USD$2bn) also make it one of the richest. Unlike a lot of SOEs, this one operates in highly-competitive markets, and has nothing like a monopoly in China.

The deal we’re working on is to restructure then “privatize” two profitable subsidiary companies of this SOE. Both of these subsidiaries are the largest businesses in China in their industry. Their combined revenues are about $220mn.

Privatization has two slightly different meanings in Chinese finance. First, is the type of deal, very common a decade ago, where big SOEs like China Mobile, Sinopec, PetroChina, ICBC, Air China, are converted into joint stock companies and then a minority share is listed through an IPO on stock markets in China, US or Hong Kong. The companies’ majority owner remains the Chinese state, with the shares usually held and managed by a powerful arm of the government known in Chinese as 国资委, in English known as the State-owned Assets Supervision and Administration Commission, or more commonly SASAC. In theory, SASAC probably holds the world’s largest and most valuable share portfolio, far bigger than Fidelity,  Vanguard, or the world’s sovereign wealth funds.

The other, rarer,  type of privatization is where a company’s majority ownership changes hands, from state to private ownership. This is the type of control deal we are working on. The plan is to spin out the two subsidiaries by selling a majority stake to either a strategic or financial acquirer. In all likelihood, each company will one day go public either in China or Hong Kong, at which time, I’d expect their market caps to each be well over US$1bn.

In essence, the deals are structured as a recapitalization, where a new private-sector majority owner will contribute capital in excess of the company’s current assessed value. That valuation is determined by an independent accounting firm,  based on current asset value.

The privatization process is heavily regulated and tightly controlled by SASAC. It involves multiple levels of review, outside valuation, and then an open-market auction process. The system has changed out of all recognition from the first generation of government asset sales done in the 1990s. These deals involved little to no public disclosure or transparency and generated quite a lot of criticism and resentment that Chinese state assets were being sold to insiders, or the well-connected, for a fraction of their true value.

For an investment bank, working with an SOE, especially a large and famous one, has a process, logic and rhythm all its own. There are many more layers of management than at a typical Chinese private company, and many more voices involved in decision-making. In this case, we’re rather fortunate that the chairman of the holding company is also the founder of the two subsidiaries we’re now seeking to spin out. He started the companies from zero less than ten years ago, and has built them into proud, successful, fast-growing businesses.

This chairman has far more sway over the strategy and direction of the SOE than is usual in China. I first met him over a year ago. I was called to visit the company to explain the process through which an SOE like his could raise outside capital. Though curious, the chairman said at the time it seemed like more trouble than it would be worth. He had a comfortable life, and was nearing mandatory retirement age.

In fact, as I now understand, that first meeting was really just a way to kickstart a long, complicated and confidential discussion process involving the chairman, his senior management team, as well as even more senior officials at the SOE.  Over the course of a year, the chairman was able to persuade himself, as well as the many others with a potential veto, that a spin-out of the two companies was worth considering in greater detail.

The privatization offers the promise of long-term access to capital and also, most likely, a greater degree of management autonomy.  Though the two subsidiaries do not sell to, rely on or otherwise have related party transactions with the parent, they are ultimately subject to some rather heavy and often-stifling bureaucratic controls. Contrary to the reputation of many Chinese SOE, the two companies sell high-end products to large fastidious global customers. They operate in highly kinetic markets but with a corporate structure above them that is as slow, ponderous and impenetrable as a five-hour Peking Opera performance.

The chairman invited me to return for another visit in June. What followed was a rather intensive process of me and my team submitting several different financing plans and options, including the privatization of either the whole holding company or various subsidiaries, either as standalones, or grouped into mini-conglomerates. These different plans got discussed very actively inside the SOE. In under a month, the company had decided how it wanted to proceed: that its two strongest and most successful subsidiaries should be separately spun off and majority control in each offered to a new investor.

It may not sound like it, but one month is a remarkably fast time for an SOE to consider, decide and then get necessary approvals to do just about anything. We also work with another even larger Beijing-headquartered SOE and it took them almost four months to get the eleven different people needed to approve, and apply the chop to, our template Non-Disclosure Agreement.

I was summoned with one day’s advance notice to return to the company in late July to sign a cooperation agreement to advise them on the proposed privatization/recapitalization of the two subsidiaries. Again, that’s rather typical of SOEs:  meetings are called suddenly, and one needs to drop whatever one’s doing and attend. For me, that meant a hastily-booked two hour flight, then a three-and-a-half hour drive to the company’s headquarters. A photo from the signing ceremony is at the top of this page. (I have to cover over the name of the company.)

The contract signing was followed by another in a series of very elaborate and extremely tasty meals. The chairman has converted a 13-acre plot of the company’s land into an organic farm, where he grows fruits and vegetables and raises free-range pigs, ducks, chickens. Everything I’ve eaten while visiting the company has come from this farm. Everything is remarkably good. And, yes, along with the food, a rather large amount of Chinese alcohol is poured.

In future posts, I’ll talk about different aspects of the transaction, including how to parse the balance sheet and P&L of an SOE, as well as the industrial and investment logic of doing a takeover of an SOE. In the current market environment in China, where so many PE minority investments are stranded with no means to exit, there has probably never been a better time to do buyout transactions, particularly of mature and successful industrial companies with scale, good profit margins and clean accounting. Good businesses like this are few. We are now working for two of them.

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Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

1 Comment / July 23, 2013

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

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