China First Capital research

Secondaries offer solution for US capital locked in China — AltAssets

Leave a Comment / May 24, 2013

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. ”

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

 

CFC’s Latest Research Report Addresses Most Treacherous Issue for Chinese Companies Seeking Domestic IPO

Leave a Comment / March 6, 2011

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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 “民营企业上市规范问题”. 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:

  1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
  2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
  3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
  4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
  5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
  6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
  7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

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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