China Investment

“A lot hasn’t gone to plan”: SuperReturn Interview

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Does [China’s] shift from a manufacturing-driven economy to a service-driven one make macroeconomic shocks like those seen this summer inevitable?

Peter Fuhrman: China has enjoyed something of a worldwide monopoly on hair-raising economic news of late: a stock market collapse followed by a klutzy bail-out, then a devaluation followed by a catastrophic explosion and finally near-hourly reports of sinking economic indicators. As someone who first set foot in China 34 years ago, my view is we’re in an unprecedented time of economic and financial uncertainty . Consumers and corporates are noticeably wobbling. For a Chinese government long used to ordering “Jump!” and the economy shouting back “How high?” this is not the China they thought they were commanding.  Everyone is looking for a bannister to grab.

And yet, China still has some powerful fundamentals working in its favour. Urbanization is a big one. It alone should add at least 3-4% to annual GDP a year for many years to come. The shift towards services and domestic growth as opposed to exports are two others. For now, these forces are strong enough to keep China propelling forward even as it tows heavy anchors like an ageing population, and a cohort of monopolistic state-owned enterprises (SOEs) that suck up too much of China’s capital and often achieve appalling results with it.

Look, the Chinese stock market had no business in the first place almost tripling from June last year to June of this. The correction was long, long overdue. It’s often overlooked that China’s domestic stock market has a pronounced negative selection bias. Heavily represented among the 3,000 listed companies are quite a number of China’s very worst companies, with the balance made up of lethargic, low-growth, often loss-making SOEs. The good companies, like Tencent or Baidu, predominantly expatriate themselves when it comes time to IPO. To my way of thinking, China’s domestic market still seems overpriced. The dead cats are, for now, still bouncing.

 

Given this overall picture, do you expect to see greater or fewer opportunities [in China] for alternative investments and why? 

Peter Fuhrman: The environment in China has been challenging, to say the least, for alternative investment firms not just in the last year, but for the better part of the last decade. A lot hasn’t gone to plan. China’s growth and opportunities proved alluring to both GPs and LPs. And yet too often, almost systematically, the big money has slipped between their fingers. Partly it’s because of too much competition, and with it ballooning valuations, from over 500 newly-launched domestic Chinese PE and VC firms. The fault also sits with home-grown mistakes, with errors by private equity firms in investment approach. This includes an excessive reliance on a single source of deal exit, the IPO, all but unheard-of in other major alternative investment environments.

Overall PE returns have been lacklustre in China, especially distributions, before the economy began to slip off the rails. In the current environment, challenges multiply. A certain rare set of investing skills should prove well-adapted: firms that can do control deals, including industry consolidating roll-ups. In other words, a whole different set of prey than China PE investors have up to now mainly stalked. These are not pre-IPO deals, not ones predicated on valuation arbitrage or the predilections of Chinese young online shoppers. There’s money to be made in China’s own Rust Belt, backing solid well-managed manufacturers, a la Berkshire Hathaway. There’s too much fragmentation across the industrial board. China will remain the manufacturing locus for the world, as well as for its own gigantic domestic market.

Another anomaly that needs correcting: Global alternative investing has been overwhelmingly skewed in China towards equity not debt. The ratio could be as high as 99:1. This imbalance looks even more freakish when you consider real lending rates to credit-worthy corporates in China are probably the highest anywhere in the advanced world, even a lot higher than in less developed places like India and Indonesia. Regulation is one reason why global capital hasn’t poured in in search of these fat yields. Another is the fact PE firms on the ground in China have few if any team members with the requisite background and experience to source, qualify, diligence and execute China securitized debt deals. There’s a bit of action in the China NPL and distress world. But, straight up direct collateralized lending to China’s AA-and-up corporates and municipalities remains an opportunity global capital has yet to seize. Meanwhile, China’s shadow banking sector has exploded in size, with over $2.5 trillion in credit outstanding, almost all of which is current. There’s big money being made in China’s securitized high-yield debt, just not by dollar investors.

 

What’s the overall story of alternative investors engaging with central planning? How would you characterise the regulatory environment?

Peter Fuhrman: China has had a state regulatory and administrative apparatus since Europeans were running around in pelts and throwing spears at one another. So, yes, there is a large regulatory system in China overseen by a powerful government that is very deeply involved in economic and financial planning and rule-making. One must tread carefully here. Rules are numerous, occasionally contradictory, oft-time opaque and liable to sudden change.

Less observed, however, and less harrowing for foreign investors is the core fact that the planning and regulatory system in China has a strong inbuilt bias towards the goal of lifting GDP growth and employment. Other governments talk this talk. But it’s actually China that walks the walk. The days of anything-goes, rip-roaring, pollute-as-you-go development are about done with. But, still the compass needle remains fixed in the direction of encouraging strong rates of growth.

The Chinese government has also gotten more and more comfortable with the fact that most of the growth is now coming from the highly-competitive, generally lightly-regulated private sector. Along with a fair degree of deregulation lately in industries like banking and transport, China also often pursues a policy of benign neglect, of letting entrepreneurs duke it out, and only imposing rules-of-the-game where it looks like a lot of innocents’ money may be lost or conned. To be sure, foreign investors in most cases cannot and should not operate in these more free-form areas of China’s economy. They often seem to be the first as well as the fattest targets when the clamps come down. Just ask some larger Western pharmaceutical companies about this.

 

In the long view, how long can the parallel USD-RMB system run? Do you expect to see the experiments in Shanghai’s Pilot Free Trade Zone (FTZ) replicated and extended? 

Peter Fuhrman: Unravelling China’s rigged exchange rate system will not happen quickly. Every baby step — and the steps are coming more fast of late — is one in the direction of a more open capital account, of greater liberalization. But, big change will all unfold with a kind of stately sluggishness in my view. Not because policy-makers are particularly wed to the notion of an unconvertible currency. There’s the deadweight problem of nearly $4 trillion in foreign exchange reserves. What’s the market equilibrium rate of the Dollar-Renminbi? Ask someone facing competition from a Chinese exporter and they’re likely to say three-to-one, or an almost 100% appreciation. Ask 1.4 billion Chinese consumers and they will, with eminent good reason, say it should be more like 12-to-one. Prices of just about everything sold to consumers in China is higher, often markedly higher, than in the US where I’m from. This runs from fruit, to supermarket staples, to housing, brand-name clothing up to ladder to cars and the fuel that powers them.

I think the irrational exuberance about Shanghai’s FTZ has slammed into the wall of actual central government policy of late.  It will not, cannot, act like a free market pathogen.

 

Reform of China’s state-owned enterprises has been piecemeal, and private equity has had patchy success with SOEs. Do you expect this to change, and why?

Peter Fuhrman: For those keeping score, reform of SOEs has yet to really put any points on the board. The SOE economy-within-an-economy remains substantially the same today as it was three years ago. Senior managers continue to be appointed not by competence, vision and experience, but by rotation. The major shareholder of all these SOEs, both at centrally-administered level as for well as those at provincial and local level, act like indifferent absentee proprietors, demanding little by way of dividends and showing scant concern as margins and return-on-investment droop year-by-year at the companies they own.

There are good deals to be done for PE firms in the SOE patch. The dirty little secret is that the government uses a net asset value system for state-owned assets that is often out-of-kilter with market valuations. Choose right and there’s scope to make money from this. But, if you’re a junior partner behind a state owner who cares more about jobs-for-the-boys than maximizing (or even earning) profits then no asset however cheaply bought will ever really be in the money.

 

TPP has been described as ‘a club with China left out’. If it comes to pass, how do you expect China to respond?

Peter Fuhrman: China has responded. Along with its rather clumsy-sounding “One Belt, One Road” initiative it also has its Asia Infrastructure Investment Bank. The logic isn’t alien to me. When American Jews were barred from joining WASP country clubs, they tried to build better clubs of their own. When Chase Manhattan, JP Morgan and America’s largest commercial banks wouldn’t hire Jews, they went instead into investment banking, where there was more money to be made anyway.

But, China may not so easily and successfully shrug off their exclusion from TPP. It increases their aggrieved sense of being ganged-up upon. The US understands this and now frets more about China’s military power. The partners China are turning to instead – especially the countries transected by the “One Belt, One Road” – look more like a cast of economic misfits, not dynamic free traders like the TPP nations and China itself. I don’t think anyone in Beijing seriously believes that increased trading with the Central Asian -stans is a credible substitute. Even so, China will not soon be invited to join the TPP. China has hardly acted like a cozy neighbour of late to the countries with the markets and with the money. Being feared may have its strategic dividends. But the neighbourhood bully rarely if ever gets invited to the block party.

 

Peter Fuhrman will be speaking at SuperReturn Asia 2015, 21-24 September 2015, JW Marriott, Hong Kong.

 

http://www.superreturnasia.com/blog/super-return-private-equity-conference/post/id/7653_A-lot-hasnt-gone-to-plan-Peter-Fuhrman-China-First-Capital-on-alternative-investments-in-the-PRC?xtssot=0

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The Economist Survey on China Business

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With a timing that can only be described as exquisite, the Economist today publishes their in-depth survey of business in China. It appears at a time when the media is brimming with stories, often in my view overblown,  about China’s economic problems and challenges. The Economist survey provides light where there’s been way too much heat of late. I couldn’t recommend more highly taking the time to read it in full.

Please click here to go direct to the survey on the Economist website. It includes nine separate articles, each offering a banquet of analysis, ideas and insights on where China’s economy, both private sector and SOE, is heading.

The author of the survey is Vijay Vaitheeswaran, the China business and finance editor. This is the first Economist China business survey in many years. It was certainly no small undertaking. China’s size, complexity and ever-morphing business environment make a comprehensive future-looking summary of this kind difficult in the extreme to do well.

I got to meet Vijay during his research phase. I took him for Tibetan food in Shenzhen. He ended up quoting me briefly in one of the articles in the survey.

Vijay paid particular attention to accelerating innovation cycles in China’s hardware industry. He spent a few days in Shenzhen including attending a kind of hacker forum for hardware geeks. He calls Shenzhen “the world’s best place to start a hardware firm” and visited my favorite exemplar of this, 18-month-old mobile phone brand OnePlus.

Quick aside, since the launch of its new model, the OnePlus 2 six weeks ago, the waiting list to buy one has grown to over five million people. If OnePlus’s factories can keep pace with the exploding demand, the company is on track to sell over $2 billion of phones in coming twelve months.

While overall highly positive about China’s economic prospects and the ambitions of its vast pool of private sector entrepreneurs, the survey sounds a note of caution. It argues that the less efficient state-owned sector appears more and more like an unevolved creature from a foregone era.  They are, the survey warns, sucking up too much of China’s capital and achieving too little with it, all the while fighting to maintain the cozy monopolies that keep the far more dynamic and efficient private sector shut out.

How much market? How much government control and ownership? All countries struggle to find a balance. China stands out because the private sector has come so far so fast. Thirty years ago when I first set foot in China there was no private sector to speak of. Now, in all but the so-called “commanding heights” of China’s economy, entrepreneurs run rampant. 1.4 billion Chinese benefit from this fact every day.

 

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Free Trade Zones, The Next Phase of Economic Reform — China National News TV Interview

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It is the world’s most watched nightly news report, China’s CCTV 7pm evening news program, “Xinwen Lianbo” (新闻联播). Simultaneously broadcast on most terrestrial tv stations in China, it has a nightly audience estimated at over 100 million.

This past week, the level of broadcast Chinese on this news program took a brief, steep dive. The reason: a short clip of me speaking Chinese led off a news report about recent economic reforms in Guangdong Province and the introduction of pilot free trade zones in Guangdong‘s three largest cities, Shenzhen, Guangzhou and Zhuhai.

You can watch the video by clicking here. (You may need to sit through a pre-roll advertisement.) My contribution is mentioning how comparatively easy it is to register a business in Shenzhen Qianhai,  the most ambitious of Guangdong’s free trade zones.

I was out of the country in Europe when the broadcast was aired, so didn’t get to watch it live. But, I knew instantly something was going on. As I sat in a lunch meeting in Switzerland at 1:15pm (7:15pm China time), calls and messages started flooding in from friends and acquaintances watching the report in China.

 

Trials and tribulations: China’s shifting business landscape highlighted in new report — Financier Worldwide

Financier

Trials and tribulations: China’s shifting business landscape highlighted in new report

BY Fraser Tennant

The deeper trends reshaping the business and investment environment in China today are the focus of a new report – ‘China 2015: China’s shifting landscape’ – by the boutique investment bank and advisory firm, China First Capital.

As well as highlighting slowing growth and a gyrating stock market as the two most obvious sources of turbulence in China at the midway point of 2015, the report also delves into the deeper trends radically reshaping the country’s overall business environment.

Chief among these trends is the steady erosion in margins and competitiveness among many, if not most, companies operating in China’s industrial and service economy. As the report makes abundantly clear, there are few sectors and few companies enjoying growth and profit expansion to match that seen in previous years.

The China First Capital report, quite simply, paints a none too rosy picture of China’s long-term development prospects.

“China’s consumer market, while healthy overall, is also becoming a more difficult place for businesses to earn decent returns,” explains Peter Fuhrman, China First Capital’s chairman and chief executive. “Relentless competition is one part, as are problematic rising costs and inefficient poorly-evolved management systems.”

To read complete article, click here.

The Shenzhen Unicorn — Week in China Magazine

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OnePlus Two

A sizeable quotient of the techno-hip crowd in the US and Europe is counting down the days to the launch next week of the newest Android mobile phone by China’s OnePlus. It’s called the OnePlus Two and follows a little more than a year after the 18-month-old company’s first phone, the OnePlue One, went on sale in the US and Europe. With barely a nickel to spend on marketing and promotion, OnePlus insouciantly dubbed its OnePlus One a “flagship killer” claiming it delivered similar or better performance than Samsung, LG and HTC Android phones costing twice as much.

The tech media swooned, and buyers formed long online queues to buy one from the OnePlus website, www.oneplus.net, the only place the phones are sold. In little more than six months last year, OnePlus sold over one million phones.

The new OnePlus model is rumored to be built around a new top-of-the-line Qualcomm processor, and features a larger screen, an upgraded in-house version of Android software, fingerprint recognition. Price? Around $300. It will be available, as was the OnePlus One for most of the last year, on an “invitation-only cash-upfront” basis to prospective buyers. How to get a coveted invitation remains something of a dark art. New OnePlus owners are given a certain number of invitations to send to whoever they please.

The July 27th launch will be an online event broadcast in virtual reality. OnePlus manufactured and is giving away a cardboard virtual reality viewer said to be as good or better than the ones sold by Google for $20. The viewers have been flying out the door for the last month.

To read complete article, click here.

 

China’s Incendiary Market Is Fanned by Borrowers and Manipulation — The New York Times

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China’s Incendiary Market Is Fanned by Borrowers and Manipulation

Focus Media Reaches $7.4 Billion Deal to List in Shenzhen — New York Times

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HONG KONG — Years after delisting in the United States after a short-selling attack, one of China’s biggest advertising companies is hoping to cash in on a market rally on its home turf.

Focus Media, a company based in Shanghai that was privatized and delisted from the Nasdaq two years ago after being targeted by short-sellers, on Wednesday reached a 45.7 billion renminbi, or about $7.4 billion, deal for a listing on the Shenzhen Stock Exchange. The transaction values Focus at about twice the $3.7 billion that its management and private equity backers — led by the Carlyle Group — paid to take the company private in 2013.

Focus and its investors, which also include the Chinese companies FountainVest Partners, Citic Capital Partners, CDH Investments and China Everbright, are trying to tap into China’s surging domestic stock markets. The main Shanghai share index has risen 51 percent this year, while the Shenzhen index, where Focus will be listed, has more than doubled, increasing by 114 percent.

Other Chinese companies that retreated from American markets, as well as their private equity backers, are likely to be watching the Focus deal closely. If it goes through and the new shares rise sharply, it could offer an incentive for others to follow suit — and give private equity firms an easier way to sell their stakes.

Some other big Chinese companies that delisted from the United States market in recent years include Shanda Interactive Entertainment, which was valued at $2.3 billion when it was privatized by its main shareholders in 2012; and Giant Interactive, which was privatized last year in a $3 billion deal.

Focus is coming back to the market through a so-called backdoor listing, in which its main assets are sold to a company already listed in exchange for a controlling stake in the listed firm. Such an approach can offer a more direct path to the market than an initial public offering — especially in mainland China, where hundreds of companies are waiting for regulatory approval for their I.P.O.s.

But such deals can also be complex. In mainland China, they often subject shareholders to lengthy periods during which they are prohibited from selling or transferring shares. Also, unlike an I.P.O., the moves tend not to help the companies involved raise cash.

“All backdoor listings are convoluted exercises, not capital-raising events,” said Peter Fuhrman, the chairman of China First Capital, an investment bank based in Shenzhen, which is in southern China. “When you do them domestically in China, they become even more hair-raising.”

Dozens of Chinese companies retreated from American exchanges in the last five years after a wave of accounting scandals and attacks by short-sellers. Some of those companies were forcibly delisted by the Securities and Exchange Commission; others were taken private by management after their share prices slumped.

Focus was the biggest of those privatizations. In November 2011, the company was targeted by Muddy Waters Research, a short-selling firm founded by Carson C. Block. Muddy Waters accused Focus of overstating the number of digital advertising display screens it operated in China, and of overpaying for acquisitions.

Focus rejected the accusations, but its shares fell 40 percent on publication of the initial report by Muddy Waters. In summer 2012, the company’s chairman, Jason Jiang, and a group of Chinese and foreign private equity firms announced plans to delist Focus and take it private, a deal that was completed in early 2013.

On Wednesday, Jiangsu Hongda New Material, a Shenzhen-listed manufacturer of silicone rubber products, said it would pay 45.7 billion renminbi, mostly by issuing new stock, to acquire control of Focus. Shares in Jiangsu Hongda have been suspended from trading since December, when it first announced plans for a restructuring that did not mention Focus. The shares remain suspended pending further approvals of the Focus deal, including from shareholders and regulators in China.

If completed, the deal would leave Mr. Jiang, the Focus chairman, as the biggest single shareholder of Jiangsu Hongda, with a 25 percent stake.

The mainland China brokerages Huatai United Securities and Southwest Securities are acting as financial advisers on the deal.

Just a few of the Chinese companies delisted from stock exchanges in the United States in recent years have attempted a new listing elsewhere.

Last year, China Metal Resources Utilization, a small metal recycling company, successfully listed in Hong Kong. It had been listed on the New York Stock Exchange, under the name Gushan Environmental Energy.

http://www.nytimes.com/2015/06/04/business/dealbook/focus-media-in-shenzhen-listing-deal.html?_r=0

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The Hidden Unicorn: China Venture Capital Fails to Spot OnePlus

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Missed investment opportunities are rarely this glaring. Despite having hundreds of firms managing billions of dollars and employing thousands of people all supposedly out scouring China for the next big thing, China’s venture capital industry not only failed to invest in the single-most successful startup in recent Chinese history, mobile phone manufacturer OnePlus, most failed even to take note of the company’s existence. Meantime, a fair chunk of the tech savvy population of Europe and the US was enduring long waits and by-invitation-only rationing system to buy one of its prized mobile phones.

Since its founding less than a year-and-a-half ago, OnePlus went from bootstrap startup to likely “unicorn” (a billion-dollar-plus valuation) faster than any company in Chinese history. Unlike China’s other unicorns — Xiaomi, Meituan, newly-merged Kuaidi and Didi Dache and drone maker DJI Innovations — OnePlus hasn’t yet raised a penny of VC or private equity money.

With its first phones going on sale just one year ago, OnePlus has racked up a rate of growth as well as a level of brand awareness in Europe and the US never seen before from a new Chinese electronics manufacturer. OnePlus is the real deal. Revenues last year from May through December were $300mn. This year, OnePlus is on track to surpass $1 billion in sales, mainly in the highly-competitive US and European mobile phone market.

Over roughly that same period, China PE and VC firms invested over $15 billion in 1,300 Chinese firms, many also operating in the mobile industry, either as manufacturers or service providers. Needless to say, not a single one of these VC-backed startups has performed as well over the last year as OnePlus, nor created half as much buzz.

If China venture capital has a big fat blind spot it’s for companies like OnePlus. That’s because China venture capital –  which now trails only the US in the number of firms and capital raised –  is most comfortable backing Chinese companies that copy a US online business model and then tweak it around the edges to make it more suitable to the China market.

OnePlus couldn’t be more dissimilar. It is disruptive, not imitative. It takes a special kind of venture investor to recognize and then throw money behind this kind of business. OnePlus’s bold idea was to compete globally, but especially in the US and European markets, against very large and very rich incumbents —Samsung, Google, LG, Motorola, HTC — by building a phone that targets their perceived weak spots. As OnePlus sees it, those competitors’ phones were too expensive, too slow, of middling quality and the Android software they run too difficult to customize. At the same time, OnePlus sought to turn the sales model in the US and Europe on its head: no retail, no carrier subsidy, phones built-to-order after the customer had paid. Until a month ago, only those with an invitation were allowed to buy.

Nothing quite like it had ever been attempted. Will OnePlus continue its ascent or eventually crash-and-burn along with other once high-flying mobile brands like Blackberry and Nokia? Whichever happens, it’s already achieved more with less than any Chinese company competing for market share in the US and Europe. That augurs well.

From my discussions with OnePlus’s 25 year-old co-founder Carl Pei, it seems few China-based venture firms sought out the company and those that did failed to make much of an impact. The company instead opted to run on a shoestring, by cutting the need for working capital by building phones only after the customer paid. They also economized on marketing and advertising, typically where much venture money gets burnt.

OnePlus spent a total of about USD$10,000 on advertising. Instead, it poured its effort and ingenuity into building a mass following on the three major US social media platforms, Youtube, Twitter and Facebook. There’s no better, cheaper or more difficult way now to establish a brand and build revenues than getting lots of praise on these social networks. OnePlus’s success at this dwarves anything previously achieved by other Chinese companies. Compared to Xiaomi, OnePlus has double the Facebook likes, four times the Twitter followers and five times more Youtube subscribers. All three, of course, remain blocked inside China itself.

Sales of OnePlus phones also got an immeasurable boost from a string of flattering reviews in some of the most influential newspapers and tech blogs in the US and Europe.

Having reached a likely billion-dollar-plus valuation and billion-dollar revenue run-rate as a very lean company, OnePlus is now near closing on its first round of venture finance. But, it is planning to raise money in Silicon Valley, not from a VC firm in China. DJI just opted for a similar strategy, raising $75 million from Accel Partners of Palo Alto at an $8 billion valuation to expand its sales and production of consumer and commercial drones. DJI, like OnePlus, is based in China’s high-tech hub, Shenzhen.

One can see a pattern here. Many of China’s more successful and globalized companies prefer to raise money outside China, either by listing shares abroad, as Alibaba did last year, or raising money direct from US venture firms. US-based venture firms were early investors in Baidu, New Oriental Education and Ctrip , all of which later went on to become multi-billion-dollar market cap companies listed in New York.

Why do so many of China’s best companies choose to raise money outside China, despite the fact there’s now so much money available here and valuations are often much higher in China than outside? I have my theories. One thing is indisputable: being local hasn’t conferred much if any advantage to China’s venture capital industry.

Being China’s hidden unicorn hasn’t evidently done OnePlus much harm. It has revealed, though, some blinkered vision at China’s venture capital firms.

 

China’s Most Successful Startup?

 

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OnePlus Never Settle

China’s most successful startup?

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Ask people in China to name the country’s most successful and innovative new mobile phone brand and most will immediately declare Xiaomi. Ask tech-savvy Americans and Europeans and they will just as quickly suggest OnePlus. Though largely still unknown in China, Shenzhen-headquartered OnePlus, established less than 18 months ago, has achieved more success more quickly in US and European markets than any other Chinese mobile phone company. It is also possibly the China’s most successful startup since Xiaomi was established five years ago.

OnePlus, by my estimate, has now joined the most exclusive club in the technology world, a “unicorn”, meaning technology startups with a valuation of over $1 billion. Other Chinese unicorns besides Xiaomi are China’s Uber, Kuaidi Dache and group buying site Meituan. Unlike those other Chinese companies, OnePlus has not yet raised any money from venture capitalists.   OnePlus is also the only truly international Chinese unicorn, since most of its sales and growth are outside China.

With just a tiny amount of seed capital,  the company began selling its phones little more than a year ago in late April 2014. Its 2014 full-year revenues were $300mn, well behind Xiaomi’s $12 billion.  But, unlike Xiaomi, OnePlus chose to focus its efforts on the US, Western Europe and India. In these places, OnePlus is doing far better than Xiaomi, and is now considered a legitimate competitor to major international Android phone brands like Korea’s Samsung, Taiwan’s HTC, Japan’s Sony and America’s Google Nexus. OnePlus is cheaper than these others, but that doesn’t seem to be the main reason its winning customers as well as enthusiastic reviews from experts. It’s mainly because of the quality of both OnePlus’s hardware and Android software.

According to the Wall Street Journal, the One Plus phone is “exceptional” and it “beats Apple iPhone 6 and Samsung Galaxy S5 in many ways.” The New York Times has called the OnePlus phone “fantastic, about the fastest Android phone you can buy, and its screen is stunning “.  Time Magazine chimed in with OnePlus is “exactly how a smartphone should be.” Engadget, the widely-read US technology blog, recently rated the best phones to buy in the US. Oneplus came out on top. That’s certainly a first for a Chinese brand.

Engadget smartphone rankingIn my seven years as an investment banker in China and before that as CEO of a California venture capital firm, I’ve never met quite such a mold-breaking company. OnePlus set out to achieve what no other Chinese company has ever done, to excel not just at making low-cost fast-to-market products but making ones of the highest quality, in engineering and design, hardware and software.

They next did something else no Chinese, and few American companies have done successfully: use social media sites Twitter, Facebook and Youtube to market its products at almost zero cost, and build a brand with a high reputation and a growing band of loyal customers and followers in the US and European markets.

Both Xiaomi and OnePlus say they plan to make most of their money from selling services and software, not from selling phones. Xiaomi has the advantage of much larger scale, with far more users. But, OnePlus may actually do better with this strategy and make more money for the simple reason that in the US and Europe, compared to China, a lot of people are accustomed to paying for mobile software and services.

OnePlus sold over one million phones last year between May and December, mainly in the US and Europe. It spent a total of about $10,000 on advertising worldwide. Samsung, by contrast, spends over $350mn a year in the US advertising its mobile phones. Worldwide, Samsung is spending over $14bn in advertising and its mobile phone market share has been declining since 2013.

On many fundamental levels, OnePlus thinks and acts differently than any other successful startup in China. Start with its two founders, Pete Lau and Carl Pei. They met while working at a Chinese domestic mobile phone and Blu-ray player manufacturer called Oppo. Lau is responsible for OnePlus’s manufacturing and product engineering, including overseeing a network of outsourced suppliers and manufacturers in and around Shenzhen. “We want to tell the world: Chinese products are great,” Lau says.

Pei’s background is more unusual. He is responsible for the company’s international growth and unique marketing strategy.  Everything about Pei – his background, his way of thinking and his approach to selling mobile phones successfully in the US and Europe – sets him well apart from all other Chinese tech entrepreneurs I’ve met. He is ethnically Chinese, but before coming to Shenzhen three years ago, had never lived or worked in China and his Chinese language ability, by his own admission, is so-so. Now 25, Pei was raised mainly in Sweden.

To understand Pei’s approach to business, it’s useful to understand something about business and culture in Sweden. It’s a small country, with less than 10 million people and fewer than 17,000 Chinese. Yet, it has arguably produced more innovative, world-changing companies, per capita, than any other country in the world. There’s a long list of them. My five favorites are furniture retailer IKEA, milk packaging company Tetra-Pak, bearing manufacturer SKF, fashion retailer H&M and music streaming company Spotify. In each case, these companies now dominate entire industries, with high-quality products and fair prices. Sweden has no real luxury brands. Instead it has a lot of great companies that have changed the ways a huge mass of people across the world live their lives, from the milk they drink to the beds they sleep on, the clothes they wear and now even the music they pay to listen to.

Sweden’s last attempt at success in mobile phones ended up badly. Ericsson once had a decent business selling basic phones, but the birth of smartphones was the death of Ericsson’s mobile business. OnePlus stands a better chance, in part because it’s a mix of Swedish focus on targeting a mass customer market together with Chinese speed and adaptability. I expect to see more of these “mixed blood” companies emerging in China, as China becomes more globalized and more welcoming to non-natives immigrating to start new businesses.

By basing itself in Shenzhen, OnePlus sits inside the world’s most densely-packed ecosystem of component, chip and contract manufacturing companies. It’s hard to imagine OnePlus could have been built as successfully anywhere else in the world. Foxconn, manufacturer of iPhones, is among the companies with its China base in Shenzhen.  Intel has also moved in in force to win business from these small, nimble Chinese electronics companies.

Manufacturing smartphones in Shenzhen is comparatively easy. Far harder is convincing Americans to buy a mobile phone without a subsidy and a service contract from a network provider like Verizon or AT&T. Yet, OnePlus is so far succeeding.  One reason: other companies that tried ended up spending millions of dollars on advertising to try to explain to Americans why they should buy a phone directly. It was mainly burned money. OnePlus spent nothing on advertising but used Twitter, Facebook, Google Plus and Youtube to build up a group of early adopters, who then went out and evangelized their friends.

OnePlus has 1.1mn “likes” on Facebook, double Xiaomi’s, along with four times as many followers on Twitter. On Youtube, the Oneplus channel has five times more subscribers than Xiaomi. Keep in mind Youtube, Twitter and Facebook are banned in China, where all of OnePlus’s employees are. OnePlus has become an expert at selling and brand-building using websites OnePlus’s own team aren’t supposed to even be looking at.

Ask Carl how he figured out how to do things in the US market that American companies, including hundreds with millions of dollars in VC money, weren’t able to do and he just shrugs, like it was all pretty easy. OnePlus still has no office in the US, no staff there, no repair centers, nothing. In the beginning you could only buy a OnePlus in the US and Europe with an invitation. Even with one, OnePlus only accepted orders from new customers one day a week, on Tuesdays.  As OnePlus’s reputation grew, the invitations became themselves valuable commodities. They still sell on eBay for $10-$20 each. OnePlus is now gradually loosening up and letting those without an invitation buy its phones, but again, only one-day-a-week, on Tuesdays.

Selling by invitation only may seem counterproductive. But, it’s proved vital to OnePlus’s success up to now. The reason: making mobile phones is generally a very cash-intensive business, since you need to have huge amounts of working capital to buy parts, build phones, supply to retail channels, and then wait for cash to return. OnePlus had no access to a big pot of working capital. So they have basically built phones to order, after the customer has paid.

One-third of the OnePlus’s 400 staff, including about 50 non-Chinese, are dedicated to customer service, which mainly means answering emails and responding to comments and questions on the company’s website and forums. This is another core thing OnePlus does better than any company I’ve seen in China. It’s establishing a new idea in the US and Europe about what a Chinese company is and does. Not just a source of cheap manufactured goods, but a company with a clear and powerful brand identity, one knows how to communicate well and sell things to college-educated 20-30 year-olds who live in San Francisco, Berlin and London.

Success has come quickly, but Pei, from my discussion over dinner with him, is certainly not complacent. He sees risks everywhere, not only from the obvious examples of Nokia and Blackberry, two once world-conquering mobile phone companies that have all but disappeared from the market. Apple remains very powerful. It and Google also own a lot of the key intellectual property patents for mobile phone signal processing, software and chip design. If either chooses to sue OnePlus, they have far more money to fight a patent lawsuit in a US court. Legal fees could easily top $20mn, money OnePlus does not now have. The US patent law system has been abused before, a big company sues a small but fast-growing one, not because it has a good legal case, but knowing that fighting the lawsuit, paying the legal bills, can put this new competitor out of business.

Pei’s three burning concerns are the OnePlus fails to attract enough talented global executives to join the company, loses its edge in designing hardware and software, or grows too large to maintain its quirky brand image and identity. OnePlus is in the process of opening new offices and moving key people from Shenzhen to Bangalore and Berlin because Pei believes it will be easier to find talented staff there.

Another worry, surprisingly, is how and when to bring in venture capital investors. OnePlus will likely try to raise money from one of the world’s famous Silicon Valley VCs. They have the most experience investing in disruptive businesses, helping startups like OnePlus to grow, especially in the US market, and they also can provide lots of help finding top executives and distribution partners. But, these Silicon Valley VCs have also not seen anything exactly like OnePlus before, a Chinese startup, likely with some core operations in India, and a magical ability to sell to Americans without having any Americans involved.  If successful, OnePlus could have one of the largest Series A VC rounds in history, raising perhaps $100mn-$200mn. Will money spoil the company or improve it?

OnePlus’s revenues are on track to more than triple this year to over $1 billion. But, there are lots of places where OnePlus could stumble and fall. Its new model launches and software upgrades could get delayed. Cost pressures could force them to raise prices in the US as they recently had to do in Europe, because of steep fall in the Euro. Also, US and European early-adopters are a fickle bunch. They could start throwing bricks at OnePlus instead of kisses. Case in point, in less than two years, Taiwanese mobile phone company HTC went from the most talked-about and fastest-growing company in the industry to an also-ran.

China’s mobile phone industry, as well as much of the TMT sector, have a reputation for being not much more than a bunch of knock-off artists, with no real innovation worthy of the name. OnePlus and Xiaomi both point the way towards a different and better future for China industry. Yes, OnePlus is good at assembling components cheaply. But, its core strengths as a company are too rarely found in China: an obsessive focus on product design, product quality, branding and customer engagement. These are what determine a company’s value as well as competitive strength. OnePlus is the first Chinese company to gain a large number of buyers and fans in the US and Europe by being simultaneously good at all these.

China’s long-term economic competiveness requires that more companies like OnePlus emerge. But, until it came along, China didn’t have a single one. It’s the most concrete sign that China may transition away from being a source of copy-cat products sold cheap and begin to play in the global big leagues, generating buzz while competing and taking market share from large, rich incumbents like Google and Samsung.

http://asia.nikkei.com/Business/Companies/China-s-most-successful-startup

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M&A the Chinese Way: Buying First and Paying Later — Financial Times

FTlogo

FT article

For these two, as well as companies wishing to find a buyer in China, the game now is to learn the new rules of China M&A and then learn to use them to one’s advantage.

Chinese companies mainly pursue M&A for the same reasons others do – to improve margins, gain efficiencies and please investors. The main difference, and it’s a striking one, is that in most cases domestic Chinese corporate buyers, especially the publicly-quoted ones who are most active now trying to do deals, have no money to buy another business.

Outside of China, there are three known ways to pay for an acquisition – with cash, borrowed money, or shares. All three are generally between excruciatingly slow and impossible for publicly-listed Chinese companies. The reason: companies’ retained earnings are just about always insufficient.

Banking and securities rules in China severely restrict the way publicly-traded companies in China can finance acquisitions using debt or by issuing new shares. Deals financed with leverage are basically forbidden. So, Chinese companies have invented two convoluted ways to get M&A done. They display a certain genius. Both involve trying to buy first and pay later.

Method One is for the acquirer to first negotiate a purchase then ask the Chinese stock market to suspend trading in its own shares. The acquirer will announce the deal publicly and if all goes to plan its share price will surge, often by as much as 50 per cent to 75 per cent.

This predictable outcome is the result of the fact almost all shares quoted in China are owned by small retail investors, commonly called Chinese brokers “old grandpas and grandmas”. Most have never cared to look at a company’s financials or studied its competitive position. Instead, they trade in and out of stocks depending mainly on rumor and hype fed to them by brokers or online tip sheets.

In China, an announced M&A deal is now always a market-moving event. The movement tends to be all in one direction. Up.

Once trading in the acquirer’s shares resumes and the price duly jumps up, the acquirer then initiates the laborious process of applying to the Chinese securities regulator, the China Securities Regulatory Commission (CSRC), for permission to do a secondary share offering.

This will then, it’s hoped, yield the cash to complete the acquisition. The approval process will generally take six months or longer. Chinese securities rules are cumbersome and mandate that the new shares be issued at a discount to the share price at the time of application.

The result: the sequence of “announce first, then apply” means the acquirer can raise the cash needed to buy the target on more favorable terms for the acquiring company, lowering the amount of dilution.

Method Two, a close cousin, is to persuade a friendly domestic investment fund to buy the target company then hold onto it for as long as it takes the intended final owner to get the money in place through the secondary offering. In other jurisdictions, this might be deemed a “concert party” and so likely to land everyone in jail. In China, it’s becoming common practice.

In fact, a new form of investment fund has come into being especially to do deals like this. They call themselves “市值管理基金” which you can translate as “market cap management funds”. They exist to help publicly-traded companies do M&A deals that will lift the company’s share price, and not much else.

They make money buying and selling shares, as well as marking up for resale companies they buy on behalf of publicly-traded companies. They are not buyout funds as understood elsewhere, since these market cap management funds are buying on behalf of a specific company and have no particular industry expertise or experience managing an acquired company. They act purely as a temporary custodian.

Most often, the acquirer will contribute a small amount of limited partner capital to the “market cap management fund” as a way to bind the two organisations together. It can take a year or more from when the market cap management fund first buys the target company then sells to the publicly-traded acquirer, and from there, several more years before this acquisition starts to have an impact, if any, on the acquiring company’s earnings. In other words, a very long timetable.

That by itself is not a problem for the acquirer, since it is as eager to give a shot of adrenalin to its own share price and maintain it on this higher plane as it is to get control of the target company and integrate it into its business. Market cap management trumps industrial logic as a reason to pursue M&A.

I’ve yet to see evidence of much skepticism from Chinese stock market investors that an announced M&A deal may not benefit the acquirer. In the US and other more developed capital markets, it’s frequently the opposite. An acquiring company will as often as not see its shares fall when it announces plans for a takeover. That’s because in most cases, as far as hard empirical evidence can determine, the main beneficiaries of any M&A deal are the target company’s shareholders. Too often, for acquirers M&A deals prove to be too expensive and synergies elusive.

We’ve been invited by domestic listed companies in China to help consult on M&A deals where “market cap management” was an explicit purpose. Finding an attractive target is also a consideration, but a somewhat secondary one.

The discussions, in the main, are unlike anywhere else where M&A deals are being planned and executed. They revolve around how to get the money together, when and for how long to halt share trading, and by how much the listed company’s shares will likely go up, and stay up, once the M&A announcement is made.

Where the publicly-listed company has private sector, rather than State-owned enterprise background, the chairman will usually be the largest single shareholder. The chairman’s net worth stands to get the biggest boost if market cap management works as planned.

Opportunities for global buyout funds
The lengthy, roundabout nature of Chinese M&A is creating attractive opportunities for global corporations and buyout firms. They are the only participants in the M&A arena in China both with cash in hand or easily accessed to close deals and the experience to manage a company well once it’s bought.

From the perspective of potential Chinese sellers, both of these are extremely valuable, since they remove much of the uncertainty in agreeing to sell to a domestic acquirer. Global corporates and buyout firms will thus often be buyers of first choice for sellers.

For now, few global corporates and buyout firms are busy closing M&A deals in China. There are a host of reasons, including China’s slowing economic growth, the perception China is becoming more hostile towards foreign investment, the difficulty persuading owners of better Chinese companies to give up majority control. All valid concerns. But, there are larger forces now at work that make it attractive to expand through acquisition in the world’s largest fast-growing market.

First, in almost all industrial and service industries, China is beginning at last a process of rationalisation and consolidation. Costs are rising quickly, especially for labor, energy and debt service. These are applying vice-like pressure on margins. Markets for most products and services in China are no longer growing by +25 per cent a year and suffer from overcapacity.

Scale, efficiency, quality, modern management are the only ways to combat the punishing margin pressure. This plays directly to the strengths of larger global corporations and buyout firms. They know how to do this, how to transform a capable smaller business into a large market-share leader.

It’s something of a well-kept secret, but some of the world’s most successful M&A deals have seen large global corporations buying private sector businesses in China. The successful buyers generally prefer it this way, that few know how well they are doing after buying and upgrading a Chinese domestic company.

Why tip off competitors? For every well-publicized horror story there are at least three quiet successes. Indeed, one can find within a single Fortune 500 company three great examples of how to do domestic M&A well in China, and achieve a big payoff. The company is Swiss food giant Nestle.

They first opened an office in China in 1908. The big transformation began a hundred years later, in 1998, when they decided to buy an 80 per cent ownership in a Chinese powdered bullion company Taitaile. That company is now more than twelve times the size it was when Nestle bought in.

They followed that up with two other large acquisitions of domestic Chinese food and beverage brands, drinks company Yinlu and candy brand Hsu Fu Chi. In all cases, Nestle bought majority control, but not 100 per cent. They kept the founder in place, as CEO and a minority owner.

That has proved a brilliant model for successful M&A in China, and not only at Nestle. When discussing with Chinese business owners the advantages of selling control to a capable global company, we often share details of Nestle’s M&A activity in China, including the fact that the Chinese owner stays but gets to spend Nestle’s money, leverage its resources, to build a giant business. That’s a pretty attractive proposition.

All three acquisitions have thrived under Nestle’s ownership and now enjoy significant market shares. Thanks largely to these acquisitions, China is Nestle’s second-largest market overall. It was number seven just four years ago.

From my discussions with the China M&A team at Nestle, they are frank that it’s not always been smooth sailing. The M&A deals all involved trying to blend one of the world’s most fastidious, slow-moving and more bureaucratic cultures with the free-wheeling, “ready, fire, aim” style common to all Chinese domestic entrepreneurs. Corporate culture gaps could not get any wider. And yet, it’s worked out well, better in fact than Nestle hoped when going in.

Nestle tells us it is hungry to do more acquisitions in China. Chinese still spend half as much on food per capita as Mexicans. That’s where the growth will come from. Market dynamics in China are also moving strongly in Nestle’s favor, as food quality and safety become paramount concerns. Further acquisitions should help Nestle gather in billions more in revenue in China along with higher market shares.

Across multiple industries, the circumstances are similar in China, and so favor smart, bold acquirers. Choose good targets, buy them at a good price, convert great entrepreneurs to great managers and partners, don’t script everything from your far-off global headquarters. Do these right and M&A can work in China. No market cap management required.

(Originally published Financial Times BeyondBrics)

http://blogs.ft.com/beyond-brics/2015/05/08/ma-the-chinese-way-buying-first-and-paying-later/

http://www.chinafirstcapital.com/en/FT.pdf

 

China First Capital Interview: Cashing in and cashing out — China Law & Practice

 

China Law & Practice

Peter Fuhrman, CEO of China First Capital, explains how the country’s private equity market has struggled with profit returns and the importance of diversified exit strategies. He also predicts the rise of new funds to execute high-yield deals

Date: 05 May 2015

What is China First Capital?

China First Capital is an investment bank and advisory firm with a focus on Greater China. Our business is helping larger Chinese companies, along with a select group of Fortune 500 companies, sustain and enlarge market leadership in the country, by raising capital and advising on strategic M&A. Like our clients, we operate in an opportunity-rich environment. Though realistic about the many challenges China faces as its economy and society evolve, we are as a firm fully convinced there is no better market than China to build businesses of enduring value. China still has so much going for it, with so much more growth and positive change ahead. As someone who first came to China in 1981 as a graduate student, my optimism is perhaps understandable. The positive changes this country has undergone during those years have surpassed by orders of magnitude anything I might have imagined possible.

After a rather long career in the US and Europe, including a stint as CEO of a California venture capital company as well as a venture-backed enterprise software company, I came back to China in 2008 and established China First Capital with a headquarters in Shenzhen, a place I like to think of as the California of China. It has the same mainly immigrant population and, like the Silicon Valley, is home to many leading private sector high-tech companies.

What is happening in China’s private equity (PE) market?

Back in 2008, China’s financial markets, the domestic PE industry, were far less developed. It was, we now can see, a honeymoon period. Hundreds of new PE firms were formed, while the big global players like Blackstone, Carlyle, TPG and KKR all built big new operations in China and raised tons of new money to invest there. From a standing start a decade ago, China PE grew into a colossus, the second-largest PE market in the world. But, it also, almost as quickly, became one of the more troubled. The plans to make quick money investing in Chinese companies right ahead of their planned IPO worked brilliantly for a brief time, then fell apart, as first the US, then Hong Kong and finally China’s own domestic stock exchanges shut the doors to Chinese companies. Things have since improved. IPOs for Chinese companies are back in all three markets. But PE firms are still sitting on thousands of unexited investments. The inevitable result, PE in China has had a disappointing record in the category that ultimately matters most: returning profits to limited partners (LPs).

Read complete interview

Foreign Investors Unfazed by Kaisa’s Default –South China Morning Post

SCMP

Foreign investors unfazed by Kaisa’s default

No increase in costs as mainland developers Jingrui and Landsea tap bond market
PUBLISHED : Saturday, 25 April, 2015, 12:38am

PE challenges and opportunities in 2015 — Financier Magazine

May 2015 Issue

PE challenges and opportunities in 2015

May 2015  |  COVER STORY  |  PRIVATE EQUITY

Financier Worldwide Magazine

May 2015 Issue


Like many other facets of the financial services industry, the private equity (PE) asset class has endured a turbulent and difficult period since the onset of the financial crisis. Critics of the industry were quick to colour the PE space as a den of iniquity, a place for vultures and destroyers of jobs. In recent years, the sector has been required to comply with an increasingly tight set of regulatory requirements.

…….

Chinese PE activity, by contrast, was rather more subdued. “In 2014, the gap between the performance of the private equity industry in China and the US opened wide,” says Peter Fuhrman, chairman and founder of China First Capital, a China-focused global investment bank. “The US had a record-breaking year, with 10-year net annualised return hitting 14.6 percent. Final data is still coming in, but it appears certain US PE raised more capital more quickly and returned more profits to LPs than any year previously. China, on the other hand, had another so-so year. Exits picked up over 2013, but still remain significantly below highs reached in 2011. As a result, profit distributions to LPs and closing of new China-focused funds are also well down on previous highs. While IPO exits for Chinese companies in the US, Hong Kong and China reached 221, compared to only 66 in 2013, the ultimate measure of success in PE investing is not the number of IPOs; it’s the amount of capital and profits paid back to LP investors. This is China PE’s greatest weakness.”

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Treating the Cancer of High Interest Rates in China — Caijing Magazine commentary

caijing

The cost of borrowing money is a huge and growing burden for most companies and municipal governments in China. But, it is also the most attractive untapped large investment opportunity in China for foreign institutional investors. This is the broad outline of the Chinese-language essay published in this week’s Caijing Magazine, among China’s most well-read business publications. The authors are me and Dr. Yansong Wang, China First Capital’s Chief Operating Officer.

Foreign investors and asset managers have mainly been kept out of China’s lucrative lending market, one reason why interest rates are so high here. But, the foreign capital is now trying to find ways to lend directly to Chinese companies and municipalities, offering Chinese borrowers lower interest rates, longer-terms and less onerous collateral than in the Rmb15 trillion (USD $2.5 trillion) shadow banking market. Foreign debt investment should be welcomed rather than shunned, our commentary argues.

If Chinese rules are one day liberalized, a waterfall of foreign capital will likely pour into China, attracted by the fact that interest rates on securitized loans here are often 2-3 times higher than on loans to similar-size and credit-worthy companies and municipalities in US, Europe, Japan, Korea and other major economies. The likely long-term result: lower interest rates for company and municipal borrowers in China and more profitable fixed-income returns for investors worldwide.

I’ve written in English on the problem of stubbornly high borrowing costs in China, including here and here. But, this is the first time I tried to evaluate the problem for a Chinese audience — in this case, for one of the more influential readerships (political and business leaders) in the country.

The Chinese article can be downloaded by clicking here.

For those who prefer English, here’s a summary: high lending rates exist in China in large part because the country is closed to the free flow of international capital. The two pillars are a non-exchangeable currency and a case-by-case government approval system, managed by the State Administration of Foreign Exchange (SAFE) to let financial investment enter, convert to Renminbi and then leave again. This makes it all but impossible to arbitrage the 1,000 basis point interest rate differential between China domestic corporate borrowers and similar Chinese companies borrowing in Hong Kong.

Foreign financial investment in China is 180-degrees different than in other major economies. In China, almost all foreign investment is in equities, either through buying quoted shares or through giving money to any of the hundreds of private equity and venture capital firms active in China. Outside China, most of the world’s institutional investment – the capital invested by pension funds, sovereign wealth funds, insurance companies, charities, university endowments — is invested in fixed-income debt.

The total size of institutional investment assets outside China is estimated to be about $50 trillion. There is a simple reason why institutional investors prefer to invest more in debt rather than equity. Debt offers a fixed annual return and equities do not. Institutional investors, especially the two largest types, insurance companies and pension funds, need to match their future liabilities by owning assets with a known future income stream. Debt is also higher up the capital structure, providing more risk protection.

Direct loans — where an asset manager lends money directly to a company rather than buying bonds on the secondary market — is a large business outside China, but still a small business here. Direct lending is among the fastest-growing areas for institutional and PE investors now worldwide. Get it right, and there’s no better place in the world to do direct corporate lending than in China.

For now, direct lending to Chinese companies is being done mainly by a few large US hedge funds. They operate in a gray area legally in China, and have so far mainly kept the deals secret. The hedge fund lending deals I’ve seen have mainly been short-term lending to Chinese property developers, at monthly interest rates of 2%-3%.

I see no benefit to China from such deals, nor would I risk a dollar of my own money. A good rule in all debt investing is whenever interest rates go above 20% a year, the lender is effectively taking on “equity risk”. In other words, there are no borrowers anywhere that can easily afford to pay such high interest rates. Anyone who will take money at that price is probably unfit to hold it. At 20% and above, the investor is basically gambling that the desperate borrower will not run out of cash while the loan is still outstanding.

Interest rates are only one component of the total cost of borrowing for companies and municipalities in China’s shadow banking system. Fees paid to lawyers, accountants, credit-rating agencies, brokerage firms can easily add another 2% to the cost of borrowing. But, the biggest hidden cost, as well as inefficiency of China’s shadow banking loan market is that most loans from this channel are one-year term, without an automatic rollover.

Though they pay interest for 12 months, borrowers only have use of the money for eight or nine months. The rest of the time, they need to accumulate capital to pay back principal at the end of one year. China is the only major economy in the world where such a small percentage of company borrowing is of over one-year maturity. China’s economy is guided by a Five Year Plan, but it’s domestic lenders operate on the shortest of all time-frames.

If more global institutional capital were allowed into China for lending, I would expect these investors to want to do their own deals here in China, negotiate directly with the borrower, rather than buying existing securitized shadow banking debt. These investors would want to do more of their own due diligence, and also tailor each deal, in a way that China’s domestic shadow banking system cannot, so that the maturity, terms, covenants, collateral are all set in ways that correspond to each borrowers’ cash flow and assets.

China does not need one more dollar of “hot money” in its economy. It does need more stable long-term investment capital as direct lending to companies, priced more closely to levels outside China. Foreign institutional capital and large global investment funds could perform a useful role. They are knocking on the door.

http://magazine.caijing.com.cn/20150330/3851367.shtml

 

Blackrock, Fidelity and others learn a painful lesson about China debt pricing

Kaisa bonds

For all the media ink spilled, including by Reuters’ excellent Asia fixed income correspondent Umesh Desai, you’d think the ongoing fight in Hong Kong between severely-troubled Chinese real estate developer Kaisa Group and its creditors was the biggest, nastiest, most portentous blood feud the capital markets have ever seen. It’s none of that. It’s a reasonably small deal ($2.5 billion in total Hong Kong bond debt that may prove worthless) involving a Chinese company of no great significance and a group of unnamed bond-holders who are screaming bloody murder about being asked to take a 50% haircut on the face value of the bonds. The creditors have brought in high-priced legal talent to argue their case, both in court and in the media. Me thinks they doth protest too much.

Nothing wrong with creditors fighting to get back all the money they loaned and interest they were promised. But, what goes unspoken in this whole dispute is the core question of what in heaven’s name were bond investors thinking when they bought these bonds to begin with. Kaisa was, if not a train wreck waiting to happen, then clearly the kind of borrower that should be made to pay interest rates sufficiently high to compensate investors for the manifold risks. Instead, just the opposite went down. The six different Kaisa bond issues were sold without problem by Hong Kong-based global securities houses including Citigroup, Credit Suisse and UBS to some of the world’s most sophisticated investors including Fidelity and Blackrock by offering average interest rates of around 8%. If Kaisa were trying to raise loans on its home territory in China, rather than Hong Kong, there is likely no way anyone would have loaned such sums to them, with the conditions attached, for anything less than 16%-20% a year, probably even higher. Kaisa’s Hong Kong bonds were entirely mispriced at their offering.

It may strain mercy, therefore, to feel much sympathy for investors who lose money on this deal. Start with the fact Kaisa, based where I am in Shenzhen, is a PRC company that sought a stock market listing and issued debt in Hong Kong, rather than at home. Not always, but often, this is itself a big red flag. Hong Kong’s stock exchange had laxer listing rules than those on the mainland. As a result, a significant number of PRC companies that would never get approval to IPO in China because of dodgy finances and laughable corporate governance managed to go public in Hong Kong. Kaisa looks like one of these. It has a corporate structure, which since 2009 has been basically illegal, that used to allow PRC companies to slip an offshore holding company at the top of its capital structure.

The bigger issue, though, was that bond buyers clearly didn’t understand, or price in, the now-obvious-to-all fact that offshore creditors (meaning anyone holding the Hong Kong issued debt of a PRC domestic company) would get treated less generously in a default situation than creditors in the PRC itself. The collateral is basically all in China. Hong Kong debt holders are effectively junior to Chinese secured creditors. True to form, in the Kaisa case, the domestic creditors, including Chinese banks, are likely to get a better deal in Kaisa’s restructuring than the folks in Hong Kong.

This fact alone should have mandated Kaisa would need to promise much sweeter returns and more protections to Hong Kong investors in order to get the $2.5 billion. Investors piled in all the same, and are now enraged to discover that the IOUs and collateral aren’t worth nearly as much as they expected. Kaisa bonds were, in effect, junk sold successfully as something close to investment grade. As long as the company didn’t pull a fast one with its disclosure – an issue still in dispute – it’s fair to conclude that bond-buyers really have no one to blame but themselves.

At this point, it’s probable many of the original owners of the Kaisa bonds, including Fidelity and Blackrock, have sold their Kaisa bonds at a loss. Kaisa’s bonds are trading now at about half their face value, suggesting that for all the creditors’ grousing, they will end up swallowing the restructuring terms put forward by Kaisa. If the creditors don’t agree, well then the whole thing will head to court in Hong Kong. If that happens, Kaisa has threatened to default, which would probably leave these Hong Kong bondholders with little or nothing. Indeed, Deloitte Touche Tohmatsu has calculated that offshore creditors in a liquidation would receive just 2.4% of what they are owed. The collateral Kaisa pledged in Hong Kong may be worth more than the paper it was printed on, but not much.

The real story here is the systematic mispricing of PRC company debt issued in Hong Kong. It’s still possible, believe it or not, for other Chinese property developers with similar structure and offering similar protections as Kaisa to sell bonds bearing interest rates of under 9%. Meantime, as discussed here, Chinese property companies in some trouble but not lucky enough to have a holding company outside China are now forced to borrow from Chinese investors, both individuals and institutions,  at 2%-3% a month.

It’s a situation rarely seen – investors in a foreign domain provide money much more cheaply against shakier collateral than the locals will. Kaisa’s current woes are part-and-parcel of at least some of the real estate development industry in China. It seems to have engaged in corrupt practices to acquire land at concessionary prices. Kaisa got punished by the Shenzhen government. It was forbidden to sell newly-built apartment units in Shenzhen. No sales means no cash flow which means no money to pay debt-holders. Kaisa is far from the first Chinese real estate developer to run into problems like this. And yet, again, none of this, the “politico-existential” risk many real estate development companies face in China, seems to have made much of an imprint on the minds of international investors who lined up to buy the 8% bonds originally. After all, the interest rate on offer from Kaisa was a few points higher than for bonds issued by Hong Kong’s own property developers.

Global institutional investors like Blackrock and Fidelity might control more capital and have far more experience pricing debt than Chinese ones. But, in this case at least, they showed they are far more willing to be taken for a ride than those on the mainland.