Less than 18 months ago, Harvard Business School published one of its famed “cases” on Kunwu Jiuding Capital (昆吾九鼎投资管理有限公), praising the Chinese domestic private equity firm for its ” outstanding performance ” and “dazzling investment results”. (Click here to read abridged copy.) Today, the situation has changed utterly. Jiuding’s “dazzling results”, along with that HBS case, look more like relics from a bygone era.
Jiuding developed a style of PE investing that was, for awhile, as perfectly adapted to Chinese conditions as the panda is to predator-free bamboo jungles in Sichuan. Jiuding kept it simple. Don’t worry too much about the company’s industry, its strategic advantage, R&D or management skills. Instead, look only for deals where you could make a quick killing. In China, that meant looking for companies that best met the requirements for an immediate domestic IPO. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations.
Jiuding’s pre-investment work consisted mainly of simulating the IPO approval process of China’s securities regulator, the CSRC. If these simulations suggested a high likelihood of speedy CSRC IPO approval, a company got Jiuding’s money. The objective was to invest and then get out in as short a period as possible, preferably less than two years. A more typical PE deal in China might wait four years or more for an opportunity to IPO.
Jiuding did dozens of deals based on this investment method. When things worked according to plan, meaning one of Jiuding’s deals got quickly through its IPO, the firm made returns of 600% or more. After a few such successes, Jiuding’s fundraising went into overdrive. Once a small domestic Renminbi PE firm, Jiuding pretty soon became one of the most famous and largest, with the RMB equivalent of over $1 billion in capital.
Then, last year, a capital markets asteroid wiped out Jiuding’s habitat. The CSRC abruptly, and without providing any clear explanation, first slowed dramatically the number of IPO approvals, then in October 2012, halted IPOs altogether. This has precipitated a crisis in China’s private equity industry. Few other PE firms are as badly impacted as Jiuding. The CSRC’s sudden block on IPOs revealed the fact that Jiuding’s system for simulating the IPO approval process had a fatal flaw. It could not predict, anticipate or hedge against the fact that IPOs in China remain not a function of market dynamics, but political and institutional policies that can change both completely and suddenly.
If Jiuding made one key mistake, it was assuming that the IPO approval system that prevailed from 2009 through mid-2012 was both replicable and likely to last well into the future. In other words, it was driving ahead at full speed while looking back over its shoulder.
Jiuding’s deals are now stranded, with no high probability way for many to achieve IPO exit before the expiry of fund life. That was another critical weakness in the Jiuding approach: it raised money in many cases by promising its RMB investors to return all capital within four to six years, about half the life cycle of a typical global PE firm like Carlyle or Blackstone.
Jiuding’s deals, like thousands of others in China PE, are part of a backlog that could take a decade or more to clear. The numbers are stupefying: at its height the CSRC never approved more than 125 IPOs a year for PE-backed companies in China. There are already 100 companies approved and waiting to IPO, 400 more with applications submitted and in the middle of CSRC investigation, and at least another 2,000-3,000 waiting for a time when the CSRC again allows companies to freely submit applications.
Jiuding’s assets and liabilities are fundamentally mismatched. That’s as big a mistake in private equity as it is in the banking and insurance industries. Jiuding’s assets — its shareholdings in well over a hundred domestic companies — are and will likely remain illiquid for years into the future. Meantime, the people whose capital it invests, mainly rich Chinese businesspeople, will likely demand their money back as originally promised, sometime in the next few years. There’s a word for a situation where a company’s near-term liabilities are larger than the liquidatable value of its assets.
In the Harvard Business School case, Jiuding’s leadership is credited with perfecting a “PE factory”, which according to the HBS document “subverted the traditional private equity business model.” They might as well have claimed Jiuding also subverted the law of gravity. There are no real shortcuts, no assembly line procedure, for making and exiting successfully from PE investments in China.
In an earlier analysis, written as things turned out just as the CSRC’s unannounced block on IPOs was coming into effect, I suggested Jiuding would need to adjust its investment methods, and more closely follow the same process used by bigger, more famous global PE firms. In other words, they would need to get their hands dirty, and invest for a longer time horizon, based more on a company’s medium term business prospects, not its likelihood of achieving an instant IPO.
Jiuding, in short, will need to focus its investing more on adding value and less on extracting it. Can it? Will it? Or has its time, like the boom years of CSRC IPO approval and +80X p/e IPO valuations in China, come and gone?