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AVCJ Magazine’s cover story, in current issue, on crisis in private equity in China caused by unexited deals, and the positive role direct secondaries might play.
Read complete article by clicking here.
The future of private equity and venture capital in China is threatened by a huge overhang of illiquid investments. US institutional investors and pension funds are at risk in a market that until recently was a source of significant investment profits. Private equity secondaries offer a potential way out, according to China First Capital.
China’s private equity industry, having grown in less than a decade from nothing into a giant rivaling the private equity industry in the US, is in the early stages of a unique crisis that could undermine the remarkable gains of recent years, according to a newly-published research report by China First Capital, an international investment bank. Over $100bn in private equity and venture capital investments is now blocked inside deals with no easy exit. A significant percentage of that capital is from limited partners, family offices, university endowments in the USA.
Private equity firms in China are running out of time and options. Exit through trade sale or M&A, a common practice elsewhere, is almost nonexistent in China. One viable solution, the creation of an efficient and liquid market in private equity secondaries in China where private equity firms could sell out to one another, has yet to develop. As a result, private equity general partners, their limited partner investors and investee companies in China risk serious adverse outcomes.
Secondary deals will likely go from current low levels to gain a meaningful share of all private equity exits in China, China First Capital said.
In all, over $130bn is now invested in un-exited private equity deals in China. The un-exited private equity and venture capital deals are screened and analysed across multiple variables, including date, investment size, tier of private equity firm, industry, price-earnings ratio.
Secondary deals potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments and return money to their limited partners, the report finds. The most acute need for exit will be investments made before 2008, since private equity firms generally need to return money to their limited partners within five to seven years. But, more recent private equity and venture deals will also need to be assessed based on current market conditions.
Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all slammed the door shut on IPOs for most Chinese companies. As a result, private equity firms can’t find buyers for illiquid shares, and so can’t return money to their Limited Partners.
“Many private equity firms are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve,†according to China First Capital’s chairman and founder, Peter Fuhrman. “The need for diversification is no less paramount for exits than entries,†he continues. “Many of the same private equity firms that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on a single path to exit: an IPO in Hong Kong or China. By itself, such dependence on a single exit path is risky. In the current environment, with most IPO activity at a halt, it looks even more so. â€
Secondary activity in China will differ significantly from secondaries done in the US and Europe, he added. Buyers will cherry-pick good deals, rather than buying entire portfolios, and escape much of the due diligence risk that plagues primary private equity deals in China. Sellers, in many cases, will be able to achieve a significant rate of return in a secondary sale and so return strong profits to their limited partners. Private equity-invested companies stand to benefit as well, since a secondary transaction can be linked to a new round of financing to provide additional growth capital to the business. In short, secondary deals in China should be three-sided transactions where all sides come out ahead.
But, significant obstacles remain. The private equity and venture capital industry in China has grown large, but has not yet fully matured. The industry is fragmented, with several hundred older dollar funds, and several thousand Renminbi firms launched more recently, some fully private and some state-owned with most falling somewhere in between.
Absent a significant and sustained surge in IPO activity in 2013, the pressure on private equity firms to exit through secondaries will intensify. According to the report, no private equity firm is now raising money for a fund dedicated to buying secondaries in China. There is a market need. As a fund strategy, private equity secondaries offer Limited Partners greater diversification across asset types and maturities in China.
Private equity has been a powerful force for good in China, the report concludes. Entrepreneurs, consumers, investors have all benefited enormously. Profit opportunities for private equity firms and Limited Partner investors remain large. Exit opportunities are the weak link. A well-functioning secondary market is an urgent and fundamental requirement for the future health and success of China’s private equity industry.
Copyright © 2013 AltAssets
As detailed follow-up to our report on the current challenging crisis of unexited PE investments in China, China First Capital has prepared a new research note. You can download the abridged version by clicking here.
This note provides far more detailed data and analysis on the unexited PE deals: by industry, original deal size, currency, round, and most importantly, “tier of PE”. This should give a more concrete understanding of the current opportunity in direct secondaries in China, as well as numerical challenges all GPs active in China will face exiting.
China First Capital is currently the only firm with this data and analysis. In addition to this note, we will also share in coming weeks three others research notes:
1. Secondary deals modeled on prospective IRR and hold periods
2. Risk-scoring metrics for primary and secondary deals in China
3. Portfolio analytics specific to primary and secondary investments in China
Beyond this work, shared as a service to our industry, to help facilitate the development of an efficient and liquid exit channel of direct secondaries in China, everything else will remain our confidential work product to be deployed only for clients that retain us. An introduction to our secondaries services is available by clicking here.
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If your Chinese is up to it – or perhaps if you want to see how well-designed the best Chinese newspapers are — click here to see the story today in China Securities News (ä¸å›½è¯åˆ¸æŠ¥) that includes both an interview with me and excerpts from our Chinese-language report on the crisis in Chinese private equity.
Unlike the sorry situation in the US and elsewhere, newspapers in China are still thriving. The leading papers, including China Securities News, have large nationwide readership and distribution, with the large profits to match. And no, the contents are not fiercely censored. If they were, no one would buy them.
I’m quite chuffed this paper devotes so much space to our report and its conclusions. It’s an affirmation of what a great job my China First Capital colleagues did in preparing the Chinese version. My own modest hope is that this article, together with several others that have appeared recently in other mainstream Chinese business publications, will help catalyze a more active discussion of the current crisis in the PE industry in China. There is, as my interview emphasizes, a lot at stake for China.
The sudden stop of both IPOs and new private equity investment in China means that private companies are being denied access to much-needed capital to finance growth. This is already beginning to have serious impact on China’s private sector and the economy as a whole. I foresee no significant change coming anytime soon. For private entrepreneurs, these are dark days indeed. Keep in mind, China’s private sector now accounts for over half of gdp — and it’s the “half” that provides most of new jobs as well as just about every product and service ordinary Chinese enjoy spending money on.
As a lot of non-Chinese speakers have heard, the Chinese words “crisis” and “opportunity” share a common root (å±æœºï¼Œæœºä¼šï¼‰. There is much wisdom in this. The current crisis in China PE is also perhaps the best opportunity ever for stronger PEs to find and close great investments, through purchases of what we call “Quality Secondaries”.
Investment opportunities don’t get much riper than this one.
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A stagnant exit market is likely to cause problems for firms that ventured into China in the boom years
Statistics rarely tell the whole story. However, as China celebrates the Year of the Snake, the most recent figures for private equity exits in the country make sobering reading for those who were convinced that the surge in private equity in the world’s most populated nation was the ticket to easy returns. In the final quarter of 2012, there was no capital raised by sponsors through primary initial public offerings of companies they backed, no capital raised through sales to strategic buyers and just $30 million from secondary buyouts, according to data from Dealogic.
That collapse in the exit market is creating a huge backlog of businesses in private equity hands that could force many companies to the wall and drive a shakeout in the industry, losing investors billions in the process. Global private equity firms, from large buyout specialists TPG Capital and Carlyle Group to mid-market players like 3i Group, all flooded
into the Chinese market raising capital from international investors for deals on the expectation of outsized returns as the economy opened and boomed. They were joined by thousands of domestic players that raised capital in local currency from the growing band of China’s wealthy individuals eager to get a slice of the market.
Incredible Success
Peter Fuhrman, chairman and CEO of investment bank China First Capital, said: “In the course of the last five years China has grown into the largest market by far for the raising and deploying of growth capital in the world. It has been an incredible success story when it comes to talking investors into opening up their wallets and allocating much-needed capital to thousands of outstanding Chinese entrepreneurs.†More…
I can’t say I ever articulated it as a goal, because it always seemed too far-fetched. But, I did achieve something today I truly value. I had an article published in a leading Chinese newspaper under my own name. Well, not the name my parents gave me, but my Chinese name, å‚…æˆ, which is how I’m generally known here. You can click here to see the article. The title, IPO黄金时代一去ä¸è¿” ç§å‹Ÿè‚¡æƒè¡Œä¸šå±æœºé‡é‡, can be translated as “With the Golden Age of IPOs Over, the Chinese PE Industry is in Crisis”.
It’s an article about problems with unexited PE investments in China, and the block on IPOs for Chinese companies. It appears in the country’s only major national business daily, called 21st Century Business Herald, in English, or 21世纪报纸 in Chinese. Calling it the “Wall Street Journal of China” is a little bit of a disservice, since it enjoys more of a dominant position, both in reputation and in its area of financial reporting, than even the Journal. And I give way to no one in my complete admiration of the WSJ. It is the only newspaper I read and value.
I’ve been an occasional online columnist for 21st Century Business Herald for a couple of years. This may have made them more comfortable when dealing with my rather unusual request, to publish in the daily paper’s news pages under my name an article I submitted to them. This isn’t something Chinese newspapers, especially the major ones, would generally ever do. Media is sensitive in China, extremely well-monitored. I’m just a guy who runs a small advisory firm 1,500 miles from Beijing, and have had no other form of official vetting.
After a day of deliberating, I got word they’d agreed to run the story. I never spoke directly to any of the editors at the newspaper. I wasn’t allowed to. One of the team that manages the online columns acted as middleman.
It was important to me to have the article, as submitted, published, under my name. The article touches on a topic that I think is both important, and little understood — that the block in IPO exits, and the simultaneous cut-off in most new PE funding for private companies in China, is beginning to do real harm to the private sector economy in China. I wanted to make that point, directly and clearly, and not have it be massaged in any way.
I’m a guest in China, and feel extraordinarily privileged to live and work here. There’s nothing in my story critical of government policies, nor should there be. This crisis in China PE industry is largely of its own making. Â Yes, the sudden stop of all IPOs does harm to PE investors. But, for years now, China’s PE industry has been overly-reliant on IPO as its one means of exit. Money flooded in and, even at the best of times, only a trickle leaked out through IPO. Now the trickle has been plugged shut. PE firms, their investors and the entrepreneurs they backed are all in serious peril. PEs may lose their LPs money, which would be very unfortunate. But, the real suffering is likely to be borne by the entrepreneurs, who may actually be doing a great job running their business, but now have a desperate unhappy investor inside and so no way to raise the additional capital they need to keep growing. They face a kind of slow asphyxiation.
Another reason I wanted the article to be published under my name was to try to make sure my company got some credit for the work we’ve done over six months to calculate and assess the scale of the problem of unexited deals in China. The article was published this morning. By lunchtime, electronic versions were popping up all over the Chinese internet, on most of the major financial news websites. In almost all cases, these repackaged versions all deleted my name and that of China First Capital. Pretty much par for the course in China. “Journalistic ethics” are two words not frequently paired in China. The pirated articles now discuss the findings of our research without ever mentioning who actually compiled it. If I were a reader, I’d wonder, “why should I believe any of these numbers when the article doesn’t tell me who the source is?” But, I guess Chinese readers aren’t that fussed.
As readers of this blog clearly will have noticed, Â me and my company have gotten rather a lot of English-language press attention lately. But, not a single one of those articles, or the whole lump combined, gives me even a fraction of the satisfaction and joy I had this morning holding a Chinese newspaper and finding my article in the middle of page 15.–
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The chairman of research firm China First Capital discusses China’s growing exit problem, and its possible impact on private equity in 2013.
A growing concern for private equity in China is the lack of IPO exits. How do you see that playing out in 2013?
“I don’t expect any substantial improvement or change in the problems that are blocking IPO exits domestically and internationally. And because the China private equity industry is significantly over-allocated to IPO exits, along with diminishing fund life, [this] will be a time of increasing difficulty for GPs. At the same time, the inability to exit will also continue to prevent [GPs] from doing new deals, and that is where the greatest economic harm will be done. Of course I don’t trivialise the importance of the $100 billion that’s locked away in unexited PE investments, but the real victims of this are going to be the private entrepreneurs of China. At this point, over half of all [China’s] GDP activity is generated from the private sector. The private equity money and the IPO money is what [businesses] need to grow, because private companies in China basically can’t borrow. They need private equity money and IPO proceeds to continue to thrive. “ More…
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From humble beginnings in 2000, the past decade has seen the Chinese private equity (PE) market blossom into a global powerhouse. However, according to a new report released by investment bank China First Capital (China First), the Chinese market is in the formative stages of a crisis which could undermine all of the extraordinary strides it has made in recent years.
The report, ‘Secondaries: A necessary and attractive exit for PE deals in China’, notes that while there have been nearly 10,000 deals worth a combined $230bn completed within the Chinese market between 2001 and 2012, around 7500 of those deals remain ‘unexited’. This has left approximately $130bn of PE and venture capital investment locked inside Chinese companies with very few exit options available. More…
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In the current difficult market environment for private equity in China, secondary transactions provide a valuable way forward. Staging successful IPOs or M&A will remain severely challenging. This is the conclusion of a proprietary research report recently completed and published by China First Capital. An abridged version is available by clicking here. You can also visit the Research Reports section of the China First Capital website.
Secondaries potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments. And yet these secondary deals still remain rare. As a result, General Partners, Limited Partners and investee companies, as well as China’s now-large private equity industry, are all at risk from serious adverse outcomes.
This new CFC research report is a data-driven examination of the potential market for secondary transactions in China, the significant scope for profit on all sides of the transaction, as well as the no less significant obstacles to the development of an efficient, liquid, stable long-term market in these secondary positions in China.
The report’s conclusion is that secondaries have the potential to benefit all three core constituencies in the China PE industry — GPs, LPs and investee companies. The universe of deals potentially available for secondary exit is large, over 7,500 unexited investments made in China by PE firms since 2000.
However, the greatest potential for both PE sellers and buyers across the short to medium term is in a group of select companies CFC terms “Quality Secondaries“. These are PE investments that fulfill four criteria:
CFC’s analysis reveals that the potential universe of “Quality Secondaries” is at least 200 companies. This number will likely grow by approx. 15%-25% a year, as funds reach latter stage of their lives and if other exit options remain limited.
At the current juncture, in this market environment, and assuming “Quality Secondary” deals are done at market valuations, these investment represent some of the better values to be found in growth capital investing in China. DD risk is significantly lower than in primary deals, and contingent risks (opportunity costs, and legal risks of pursuing other non-IPO exits) are lower.
Despite the current lack of significant deal-making activity in this area, secondaries will likely go from current low levels to gain a meaningful share of all PE exits in China.
The secondaries market in China will have unique factors compared to the US, Europe and elsewhere. There will likely be limited investor interest in any secondary deal involving a Chinese company or a portfolio that has underperformed since PE investment, or could otherwise be characterized as a “distress” situation.
Quality Secondaries transactions in China will involve PE investors “cherry-picking” good companies at fair valuations. The primary motivation for selling PEs is misalignment between its remaining fund life and the time required and risk inherent in achieving domestic or offshore IPO or trade sale exit during that shortened time frame.
In contrast with secondary deals done outside China, we do not expect to see much activity involving the sale of all or most of a PE firm’s portfolio of investments. Specialist secondary firms operating elsewhere (e.g. Coller Capital, Harbourvest) do not currently have the experience or manpower in China to take on the complexities of managing and liquidating all or most of an existing portfolio of minority investments.
Rather, we expect those PEs with strong operating performance in growth capital investing in China to exploit favorable market conditions by becoming active buyers of Quality Secondaries.  GPs that prefer larger deals, (+USD25mn/Rmb200mn), should be particularly interested in Quality Secondaries, since company scale and investment amount will likely be larger, on average, than primary deals in China.
Selling PEs can pursue exit strategies based on option of selling either part or all of a successful unexited deal. A part liquidation in Quality Secondary transaction can mitigate risk and return capital to LPs while still retaining future upside. A full exit through secondary can increase fund’s realized IRR and so assist future fundraising. Importantly, a selling PE needs to act before pricing leverage is transferred mainly to buyers — generally this means secondary deals should be evaluated and priced in market when fund still has minimum of two years left of active period.
While clearly the most acute need for exit will be investments made before 2008, more recent investments need also to be assessed based on current market conditions. Many GPs are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve.
In particular, much of this “wait and see” approach is based on the hope that Hong Kong’s once-vibrant, now-moribund IPO market for Chinese companies returns to its earlier state. The US stock market will certainly remain off limits to most Chinese companies for a long time to come. Exit through China’s domestic stock market is now seriously blocked by bureaucratic slowdowns and an approval backlog that even under optimistic scenarios could take three to five years to clear.
The need for diversification is no less paramount for exits than entries. Many of the same PEs that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on  a single path to exit: the Hong Kong IPO.  By itself, such dependence on a single exit path is risky. In the current environment, it looks even more so.
The flood of Chinese IPOs in Hong Kong basically came to a halt a year ago. Â When they do resume, it may prove challenging for all but the best and biggest Chinese companies to successfully issue shares there. What will become of the other deals? How will GPs and LPs profit from investments already made? That’s the focus on this new report, titled, “China Secondaries: Â The Necessary & Attractive Exit For Private Equity Deals in China“.
China First Capital (ä¸å›½é¦–创）published two new research reports, one in English and one Chinese. Both are now available for download here. The contents are different, as is the focus.
To download the English report, titled “Private Equity in China 2012: The Pace of Change Quickens“, Click here
For the Chinese report, “2012-2013 ä¸å›½ç§å‹Ÿè‚¡æƒèžèµ„与市场趋势” Click here
In fact, “No Exit” would be the more appropriate title for a report about private equity in China this year. Jean-Paul Sartre‘s famous play of that name is a conversation between three dead people stuck in hell. They are eternally damned. PE funds currently stuck inside Chinese investments with no way to exit are not in such a hopelessly miserable situation. But, some may be feeling that way.
Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all pretty much slammed the door shut on IPOs for Chinese companies. In previous years, over 300 Chinese companies would IPO. This year, that number will fall by at least 80%, maybe more. Stock markets in the US, Hong Kong and China all have slightly different explanations for the sharp drop-off in IPOs of Chinese companies. But, a common thread runs throughout: a deep distrust among investors and regulators of the accuracy of Chinese companies’ financial accounts. The view is that a Chinese company’s IPO prospectus may be as much a work of fiction as the Sartre play. Under such circumstances, companies can’t IPO, and PE firms can’t find buyers for their illiquid shares.
China’s domestic stock markets were the last to bar the door against Chinese IPOs. Until mid-year, China’s all-powerful securities regulator the CSRC was continuing to process and approve IPO applications, and companies were going public at a rate of about five a week. Then, in July, the whole complex system of approving and placing IPO shares basically stopped functioning. A Chinese company called Xindadi (新大地） exposed a serious defect at the heart of the regulatory system in China. The CSRC’s primarily function is to stop any bad company with dodgy accounts from accessing China’s domestic capital markets. Layer upon bureaucratic layer is piled up inside the CSRC to prevent officials from conspiring together to let a bad company’s application pass through. The underwriter, the lawyers and accountants are also held legally accountable to detect and expose bad companies. Yet Xindadi managed to slip through.
Xindadi’s IPO application was approved by the CSRC and the company was waiting its turn to go public when media reports surfaced that described a rather clumsy, though, nearly-successful fraud. Xindadi’s financial accounts  turned out to be fake from top to bottom. Xindadi’s business model is aptly summarized by comments made nearly a century ago by the US Federal Trade Commission about another rogue outfit, ” fraud, deceit, misrepresentation, dishonesty, breach of trust and oppression.”
The Xindadi IPO was pulled before the underwriters could sell any shares. The CSRC went into a kind of post-traumatic shock from which it’s yet to recover. It basically stopped approving new IPOs in most cases. Meanwhile the number of Chinese companies who’ve filed for IPO continues to lengthen, and now is over 800. If and when the CSRC goes back to its previous rate of approving IPOs, which isn’t likely anytime soon, it would take four years to clear this backlog.
Predictably, for PE firms in China, “No Exit” has now turned into “No Entrance”. Not knowing when IPO windows will reopen, PE firms have mainly stopped doing new deals. Chinese private sector companies, for whom PE is the main source of growth capital, are feeling the pinch. Equity capital, even for good companies, is difficult, if not impossible, to come by. The abrupt cut-off of PE financing will certainly lead to slower growth and fewer new jobs in China.
IPOs of Chinese companies in the US, Hong Kong and China have been an important, if little recognized, part of China’s growth story over the last decade. They fueled the boom in private equity — both the creation over the last five years of hundreds of new PE firms and the raising of tens of billions of dollars in new capital – and with it, a huge increase in total net new investment into China’s private sector companies. Chinese investment, particularly spending by state-owned companies, and government-backed infrastructure projects, is still largely financed by bank lending. But, the equity capital provided by PE firms has played a key part in financing the growth of larger private companies in China. PE money has underpinned increased competition, choice and economic dynamism in China.
Now that gusher of PE money has turned to a trickle. What next for private equity and corporate finance in China? The two new CFC reports summarize some of the main developments and trends in private equity and capital markets this year, and makes some predictions about the year to come. The Chinese-language report was written, as are other CFC Chinese reports, for the specific use and reference of domestic Chinese business-owners and senior management. The key message is that it’s getting far more difficult for companies to raise money, either through private placement or IPO.
The English report focuses more heavily on what’s going on in the private equity industry in China. Unlike many, I remain overall extremely positive about the fundamentals in China, that PE investment in China’s growing private sector companies represents the best risk-adjusted investment opportunity in the world. While exits through IPO are far fewer, China’s strongest investment asset remains firmly in place:Â the compounded genius of its millions of private entrepreneurs to create wealth and push forward positive social and economic change.
Around the time of Confucius 2,500 years ago, the Greek philosopher Heraclitus wrote, “Nothing is permanent except change.†It’s a perfect quick summary of the private equity industry in China. In its short 20 year history, PE in China has undergone continuous transformation: from dollars to Renminbi; from a focus on technology companies to a preference for traditional industries; from overseas IPO exits to domestic listings;  from a minor financing channel to a main artery of capital to profitable private companies competing in the most dynamic and fast-growing major market in the world.
Where is private equity in China headed? Can future performance match the phenomenal returns of recent years? Where in China are great entrepreneurial opportunities and companies emerging? These are some of the questions we’ve sought to answer in China First Capital’s latest English-language research report, titled “Private Equity in China, Positive Trends and Growing Challengesâ€.
You can download a copy by clicking:Â Â Download “Private Equity in China, 2012 – 2013“.
Our view is that 2012 will be a year of increasingly fast realignment in the PE industry. With the US capital markets effectively closed to most Chinese companies, and Hong Kong Stock Exchange ever less welcoming and attractive, the primary exit paths for China PE deals are domestic IPO and M&A. Both routes are challenging. At the same time, there are too many dollar-based investors chasing too few quality larger deals in China.
“Adapt or die” describes both the Darwinian process of natural selection as well as the most effective business strategy for PE investing in China.
I’ve been working with entrepreneurs for most of my 30 year business career. It’s the joy and purpose of my life. Good entrepreneurs profit from change and uncertainty. Investors less so, if at all. This may be the biggest misalignment of all in Chinese PE. The entrepreneurial mindset is comfortable with constant change, with the destruction and opportunity created by market innovation. In my view, the PE firms most likely to succeed in China are those led by professionals with this same entrepreneurial mindset.
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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.
More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.
My firm has just published a Chinese-language research report on the topic, titled “民è¥ä¼ä¸šä¸Šå¸‚规范问题â€. You can download a copy by clicking here or from Research Reports page of the CFC website.
The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.
For English-only speakers, here’s a summary of some of the key points in the report:
We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.
Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai“ ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.
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THE town of Alpha in Queensland, Australia, has only 400 residents, including one part-time ambulance driver and a lone policeman, according to Mark Imber of Waratah Coal, an exploration firm. But over the next few years it should quintuple in size, thanks to an A$7.5 billion ($7.3 billion) investment by his company and the Metallurgical Corporation of China, a state-owned firm that serves China’s mining and metals industry. This will build Australia’s biggest coal mine, as well as a 490km (300-mile) railway to carry the black stuff to the coast, and thence to China’s ravenous industrial maw.
It is hard to exaggerate the Chinese economy’s far-reaching impact on the world, from small towns to big markets. It accounted for about 46% of global coal consumption in 2009, according to the World Coal Institute, an industry body, and consumes a similar share of the world’s zinc and aluminium. In 2009 it got through twice as much crude steel as the European Union, America and Japan combined. It bought more cars than America last year and this year looks set to buy more mobile phones than the rest of the world put together, according to China First Capital, an investment bank.
In China growth of 9.6% (recorded in the year to the third quarter) represents a slowdown. China will account for almost a fifth of world growth this year, according to the IMF; at purchasing-power parity, it will account for just over a quarter.
For the first 25 years of its rise, China’s influence was most visible on the bottom line of corporate results, as it allowed firms to cut costs. More recently it has become conspicuous on the top line. Audi, a luxury German carmaker, sold more cars in China (including Hong Kong) than at home in the first quarter. Komatsu of Japan has just won an order for 44 “super-large dump trucks†from China’s biggest coal miner.
The Economist has constructed a “Sinodependency indexâ€, comprising 22 members of America’s S&P 500 stockmarket index with a high proportion of revenues in China. The index is weighted by the firms’ market capitalisation and the share of their revenues they get from China. It includes Intel and Qualcomm, both chipmakers; Yum! Brands, which owns KFC and other restaurant chains; Boeing, which makes aircraft; and Corning, a glassmaker. The index outperformed the broader S&P 500 by 10% in 2009, when China’s economy outpaced America’s by over 11 percentage points. But it reconverged in April, as the Chinese government grappled with a nascent housing bubble.
China is, in itself, a big and dynamic part of the world economy. For that reason alone it will make a sizeable contribution to world growth this year. The harder question is whether it can make a big contribution to the rest of the world’s growth.
China is now the biggest export market for countries as far afield as Brazil (accounting for 12.5% of Brazilian exports in 2009), South Africa (10.3%), Japan (18.9%) and Australia (21.8%). But exports are only one component of GDP. In most economies of any size, domestic spending matters more. Thus exports to China are only 3.4% of GDP in Australia, 2.2% in Japan, 2% in South Africa and 1.2% in Brazil (see map).
Export earnings can, of course, have a ripple effect throughout an economy. In Alpha, the prospect of selling coal to China is stimulating investment in mines, railways and probably even policing. But these “multipliers†are rarely higher than 1.5 or 2, which is to say, they rarely do more than double the contribution to GDP. Moreover, just as expanding exports add to growth, burgeoning imports subtract from it. Most countries outside East Asia suffered a deteriorating trade balance with China from 2001 to 2008. By the simple arithmetic of growth, trade with China made a (small) negative contribution, not a positive one.
China plays a larger role in the economies of its immediate neighbours. Exports to China accounted for over 14% of Taiwan’s GDP last year, and over 10% of South Korea’s. But according to a number of studies, roughly half of East Asia’s exports to China are components, such as semiconductors and hard drives, for goods that are ultimately exported elsewhere. In these industries, China is not so much an engine of demand as a transmission belt for demand originating elsewhere.
The share of parts and components in its imports is, however, falling. From almost 40% a decade ago, it fell to 27% in 2008, according to a recent paper by Soyoung Kim of Seoul National University, as well as Jong-Wha Lee and Cyn-Young Park of the Asian Development Bank. This reflects China’s gradual “transformation from being the world’s factory, toward increasingly being the world’s consumer,†they write. Gabor Pula and Tuomas Peltonen of the European Central Bank calculate that the Philippine, South Korean and Taiwanese economies now depend more on Chinese demand than American.
Trade is not the only way that China’s ups and downs can spill over to the rest of the world. Its purchases of foreign assets keep the cost of capital down and its appetite for raw materials keeps their price up, to the benefit of commodity producers wherever they sell their wares. Its success can boost confidence and productivity. One attempt to measure these broad spillovers is a paper by Vivek Arora and Athanasios Vamvakidis of the IMF. According to their estimates, if China’s growth quickened by 1 percentage point for a year, it would boost the rest of the world’s GDP by 0.4% (about $290 billion) after five years.
Since the crisis, China has shown that its economy can grow even when America’s shrinks. It is not entirely dependent on the world’s biggest economy. But that does not mean it can substitute for it. In April the Bank Credit Analyst, an independent research firm, asked what would happen if China suffered a “hard landingâ€. Its answer to this “apocalyptic†question was quite “benignâ€. As it pointed out, Japan at the start of the 1990s accounted for a bigger share of GDP than China does today. Its growth slowed from about 5% to 1% in the first half of the 1990s without any discernible effect on global trends. It is hard to exaggerate China’s weight in the world economy. But not impossible.
http://www.economist.com/node/17363625
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CFC has just published its latest Chinese-language research report. The title is 《ç§å‹ŸåŸºé‡‘å¦‚ä½•åˆ›é€ ä»·å€¼ã€‹, which I’d translate as “How PE Firms Add Value â€.
You can download a copy here: Â How PE Firms Add Value — CFC Report.Â
China is awash, as nowhere else in the world is, in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China.Â
In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the sameâ€. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not.Â
In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.
They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion.Â
A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrowâ€. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy.Â
But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away?Â
These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.
These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company.Â
It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments.Â
Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investorsâ€.
Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.  Â
Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business. In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.
The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.
While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment.Â
In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO.Â
At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention.Â
The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.
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China’s private equity industry is on track to break all records in 2010 for number of deals, number of successful PE-backed IPOs, capital raised and capital invested. This record-setting performance comes at a time when the PE and VC industries are still locked in a long skid in the US and Europe.
According to my firms’s latest research report, (see front cover above)  the best days are still ahead for China’s PE industry. The Chinese-language report has just been published. It can be downloaded by clicking this link: China First Capital 2010 Report on Private Equity in China
We prepare these research reports primarily for our clients and partners in China. There is no English version.
A few of the takeaway points are:
Our goal is to be a thought leader in our industry, as well as providing the highest-quality information and analysis in Chinese for private entrepreneurs and the investors who finance them.
