China Private Equity

CFC’s Annual Report on Private Equity in China

Leave a Comment / May 2, 2011

2010 is the year China’s private equity industry hit the big time. The amount of new capital raised by PE firms reached an all-time high, exceeding Rmb150 billion (USD $23 billion). In particular, Renminbi PE funds witnessed explosive growth in 2010, both in number of new funds and amount of new capital. China’s National Social Security Fund accelerated the process of investing part of the country’s retirement savings in PE. At the same time, the country’s largest insurance companies received approval to begin investing directly in PE, which could add hundreds of billions of Renminbi in new capital to the pool available for pre-IPO investing in China’s private companies.

China First Capital has just published its third annual report on private equity in China. It is available in Chinese only by clicking here:  CFC 2011 Report. Or, you can download directly from the Research Reports section of the CFC website.

The report is illustrated with examples of Shang Dynasty bronze ware. I returned recently from Anyang, in Henan. Anyone with even a passing interest in these early Chinese bronze wares should visit the city’s splendid Yinxu Museum.

This strong acceleration of the PE industry in China contrasts with situation in the rest of the world. In the US and Europe, both PE and VC investments remained at levels significantly lower than in 2007. IPO activity in these areas remains subdued, while the number of Chinese companies going public, and the amount of capital raised, both reached new records in 2010. There is every sign 2011 will surpass 2010 and so widen even farther the gap separating IPO activity for Chinese companies and those elsewhere.

The new CFC report argues that China’s PE industry has three important and sustainable advantages compared to other parts of the world. They are:

  1. High economic growth – at least five times higher in 2010 than the rate of gdp growth in the US and Europe
  2. Active IPO market domestically, with high p/e multiples and strong investor demand for shares in newly-listed companies
  3. A large reservoir of strong private companies that are looking to raise equity capital before an IPO

CFC expects these three trends to continue during 2011 and beyond. Also important is the fact that the geographic scope of PE investment in China is now extending outside Eastern China into new areas, including Western China, Shandong,  Sichuan. Previously, most of China’s PE investment was concentrated in just four provinces (Guangdong, Fujian, Zhejiang, Jiangsu) and its two major cities, Beijing and Shanghai. These areas of China now generally have lower rates of economic growth, higher labor costs and more mature local markets than in regions once thought to be backwaters.

PE investment is a bet on the future, a prediction on what customers will be buying in three to five years. That is the usual time horizon from investment to exit. China’s domestic market is highly dynamic and fast-changing. A company can go from founding to market leadership in that same 3-5 year period.  At the same time, today’s market leaders can easily fall behind, fail to anticipate either competition or changing consumer tastes.

This Schumpetrian process of “creative destruction” is particularly prevalent in China. Markets in China are growing so quickly, alongside increases in consumer spending, that companies offering new products and services can grow extraordinary quickly.  At its core, PE investment seeks to identify these “creative destroyers”, then provide them with additional capital to grow more quickly and outmaneuver incumbents. When PE firms are successful doing this, they can earn enormous returns.

One excellent example: a $5 million investment made by Goldman Sachs PE in Shenzhen pharmaceutical company Hepalink in 2007.  When Hepalink had its IPO in 2010, Goldman Sachs’ investment had appreciated by over 220 times, to a market value of over $1 billion.

Risk and return are calibrated. Technology investments have higher rates of return (as in example of Goldman Sachs’s investment in Hepalink)  as well as higher rates of failure. China’s PE industry is now shifting away from investing in companies with interesting new technologies but no revenue to PE investment in traditional industries like retail, consumer products, resource extraction.  For PE firms, this lowers the risk of an investment becoming a complete loss. Rates of return in traditional industries are often still quite attractive by international standards.

For example: A client of CFC in the traditional copper wire industry got PE investment in 2008. This company expects to have its IPO in Hong Kong later this year. When it does, the PE firm’s investment will have risen by over 10-fold.  Our client went from being one of numerous smaller-scale producers to being among China’s largest and most profitable in the industry. In capital intensive industries, private companies’ access to capital is still limited. Those firms that can raise PE money and put it to work expanding output can quickly lower costs and seize large amounts of market share.

Our view: the risk-adjusted returns in Chinese private equity will continue to outpace most other classes of investing anywhere in the world. China will remain in the vanguard of the world’s alternative investment industry for many long years to come.


 

 

 

Entrepreneurship in China– The Fuel in the Economy’s Engine

1 Comment / April 26, 2011

Fish bowl from China First Capital blog

China’s only abundant and inexhaustible natural resource is the entrepreneurial talent of its people. Nowhere else in the world can match the number of talented businesspeople, both in absolute numbers and as a share of the active population. That’s what I’ve learned in a 25-year career working alongside great entrepreneurs in the US, Europe and Asia. Today’s China is the most entrepreneurially-endowed place in the world. What that means, above all, is that China’s economy, propelled by robust entrepreneurial activity,  will prosper for the next several decades at least.

Entrepreneurs everywhere seem to share a common gene, and have more in common with one another than they do with the rest of the population in their home countries. They are more tolerant of risk, more compelled to try or invent new things, more able to see opportunities for profit, especially when they are invisible to others.

But, in China, entrepreneurs have some unique characteristics compared to those in the US and Europe. For one thing, until comparatively recently, China’s economy was a near-perfect socialist vacuum in which entrepreneurship could not survive.  The economy was almost entirely in state hands. Laws giving equal treatment to private companies were only introduced in 2005. Decades of pent-up entrepreneurial energy were unleashed. More great private companies have been started in the last ten years in China than in any other place in history.

We are still in the early years of the Big Bang of Chinese entrepreneurship. Everyone in the world is feeling the effects. Within China, private entrepreneurs now supply much of what China’s vast consumer market buys. Outside China, much of what’s labeled “Made in China” is produced in factories started and run by these new entrepreneurs.

There are some other important ways in which China’s entrepreneurs are different than those in US and Europe. A very minor percentage of China’s entrepreneurs are university graduates. They build their companies with almost no capital, and no access to bank credit. They face daunting challenges unknown to entrepreneurs most everywhere else: an absence of clear commercial laws or intellectual property protection, very burdensome tax and labor rules, holdover policies that give state-owned companies significant advantages.

Despite it all, every year, more of China’s population are going into business for themselves. Not all will build billion-dollar businesses. But, more will do so in China over the next several decades than anywhere else.

Partly, it’s simple math: China has both a huge domestic market and is the world’s largest manufacturing and exporting nation. But, these factors are themselves the product of China’s earlier entrepreneurial success, not a precondition for it. Earlier entrepreneurs created the fertile environment for today’s new private companies to thrive. The process is cumulative, and very fast-moving.. I see this every day in my work. We are meeting more great entrepreneurs now, on a weekly basis, than we did three, six or twelve months ago.

Another fact stands out when I compare these Chinese entrepreneurs to others I’ve worked with in the US and Europe. Chinese entrepreneurs do most everything single-handedly. They build companies without relying on a big management team or a circle of advisors. Decision-making is mainly based on hunch and experience, not on market research or focus groups. Even large private companies in China are managed like sole proprietorships. Nothing of importance is delegated. One person controls all the decision-making levers, casting the one and deciding vote on any issue of importance to do with operations, marketing, finance, strategy, sales. They are lone navigators, steering their businesses through very tricky waters, dealing with government officials, suppliers, customers, as well as their own employees.

Since starting China First Capital three years ago, I’ve been fortunate enough to meet several hundred outstanding Chinese entrepreneurs from dozens of different industries. Most are cut from the same cloth — crisp, confident, charismatic. With few exceptions, most do not have college degrees or much experience working for anyone else. They are born entrepreneurs.

Take one boss I met recently. He began his working life 30 years ago, after high school, as a trader. He was good at it, and saved enough, eventually, to go into manufacturing one of the products he was selling as a wholesaler to others. He moved up quickly, from producing basic low-margin commodity products to investing in his own R&D. He kept plowing profits back into the R&D work, and then to build new factory lines to produce a range of unique, patent-protected products he invented. These products deliver higher margins and target a larger, richer market than anything he previously manufactured.

The business is now growing very swiftly. Also typical, his son has joined the business, after getting a college degree abroad.  This boss, like most others I have met, knows how to work the system to his maximum advantage. His new products let him qualify as a high-tech enterprise, and so pay a much lower corporate income tax rate. The local government has shown its further support by selling him a large tract of land to build a new factory on, at a fraction of its market price.

This boss, somewhat uncommonly, has a very strong management team around him to manage finances, factory production and marketing. He is the force of gravity holding whole business together. It’s hard to imagine anyone else, except perhaps one day his son, could run this business as well. That’s another characteristic shared by most good entrepreneurial companies in China – they are never quite as successful once the founder steps down.

Another distinguishing trait of entrepreneurship in China – there are far more women bosses here than I ever saw in the US or Europe.  The ones I’ve met, along with being successful entrepreneurs, are also all quite elegant, attractive, even seductive. Those aren’t words usually associated with entrepreneurs anywhere else in the world.

According to the magazine China Entrepreneur, there are currently more than 29 million female entrepreneurs in China,  or about 20% of the total number of entrepreneurs in the country. Overall, China has more entrepreneurs, male and female, than most countries have citizens.

China’s economy continues to perform at a level never achieved by a major economy. Can this continue? I believe it can. The most emphatic reason is the entrepreneurial genius of so many of its citizens.

 

 

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How Big Can PE Industry in China Grow?

Leave a Comment / April 12, 2011

Ivory carved vase

By one conventional measure, China’s private equity industry is still a fraction of the size of larger developed economies. The PE penetration rate calculates the total annual flow of private equity finance as a percentage of total GPD. In China, the PE penetration rate is currently 0.1% of GDP. In the US, it’s eight times larger. In the UK, the flow of PE funding 2% of GDP, or twenty times the size of China.

While this calculation of PE penetration rate correctly suggests China’s PE industry still has significant room for growth, it is also somewhat misleading. It’s an apples-and-oranges comparison. Private equity in the US and Europe is mainly used to take over large underperforming businesses or subsidiaries of big public companies. These are control investments, usually financed with heavy amounts of borrowed money and a relative sliver of equity. These deals routinely exceed $1 billion. Indeed, during the first half of this year, the ten largest PE deals, all involving US companies, had total transaction value of over $20 billion.

In China, these sort of leveraged buyout deals, for the most part,  are impossible. PE capital in China flows almost entirely into minority investments in profitable fast-growing private companies. Typical deal size is $10mn for 15%-20% of a company’s shares. Deals of this kind are far more rare in the US and UK.

The more accurate term for Private Equity investing in China is “growth capital investment.” The goal is to add fuel to a fire, providing a fast-growing company with additional capital to build new factories or expand its sales and distribution channels. This kind of investing has a far higher success rate than PE investing in the US and Europe. In China, PE firms support winners. In the rest of the world, PE firms generally try to heal the wounded.

If you measured the penetration rate of growth capital investment, I have no doubt China would now be number one in the world. Nowhere else in the world can match China in the number of great private companies that are growing by over 30% a year, have the scale, experience, management and market leadership to continue to double in size every two to three years. The only real limiting factor is a shortage of capital. That’s where PE firms come in. They invest, monitor, then exit a few years later through an IPO.

That’s another big difference between PE in China and the rest of the world. PE investors in China don’t work nearly as hard as they do elsewhere. In China, the hardest part is finding good companies and then agreeing on the size and valuation of an investment. After that, it’s usually smooth sailing. In the US and Europe, it’s not only difficult to find good investment opportunities. The big challenge begins after an investment is made, in designing and then implementing often complex, risky restructuring plans, including a lot of hiring and firing.

With so much bank borrowing involved, short-term cash-flow problems can prove fatal for the PE firm’s investment. Miss an interest payment and banks can seize the business, wiping out the PE firm’s equity investment. A notable example: Cerberus’s leveraged takeover of US automaker Chrysler. Within six months of the deal’s closing, Cerberus’s $7.4 billion investment was mainly wiped out when Chrysler’s sales plummeted.

In China, PE deals also occasionally turn sour. But, the most common reason is fraud or simple theft. PE money goes into a company and disappears, usually into personal bank account of the company’s boss. This isn’t very common. But, it does happen. The PE firm will usually have a legal right to take control of a company if its money is lost or misused. But, the legal process can be slow and the outcome uncertain. By the time a PE gains control, just about everything of value can be drained out of the company. The PE firm ends up owning 100% of a business worth far less than what they put into it.

In China, PE firms often play the role of a disciplinarian, setting up rules and doling out cash as a reward for good behavior. In the US and Europe, the PE is more like a doctor in a trauma ward.

McKinsey & Company, the global consulting firm, has estimated that China’s private equity fund penetration rate could more than quadruple in the next five years, to reach 0.5% of GDP.  If so, the annual amount of PE capital flowing into private companies could reach Rmb200 billion (US$30 billion.)  There are certainly enough good investment opportunities.

At this point, the main thing holding the industry back is a lack of strong, talented people inside PE firms. Great entrepreneurs vastly outnumber great investors in China.

 

 

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Taxed At Source: Renminbi Private Equity Firms Confront the Taxman

Leave a Comment / March 15, 2011

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The formula for success in private equity is simple the world over: make lots of money investing other people’s money, keep 20% of the profits and pay little or no taxes on your share of the take. This tax avoidance is perfectly legal. PE firms are usually incorporated as offshore holding companies in tax-free domains like the Cayman Islands.

Depending on their nationality, partners at PE firms may need to pay some tax on the profits distributed to them individually. But, some quick footwork can also keep the taxman at bay. For example, I know PE partners who are Chinese nationals, living in Hong Kong. They plan their lives to be sure not to be in either Hong Kong or China for more than 182 days a year, and so escape most individual taxes as well. Even when they pay, it’s usually at the capital gains rate, which is generally far lower than income tax.

The tax efficiency is fundamental to private equity, and most other forms of fiduciary investing. If the PE firm’s profits were assessed with income tax ahead of distributions to Limited Partners (“LPs”), it would significantly reduce the overall rate of return, to say nothing about potentially incurring double taxation when those LPs share of profits got dinged again by the tax man.

China, as everyone in the PE world knows, is very keen to foster growth of its own homegrown private equity firms. It has introduced a raft of new rules to allow PE firms to incorporate, invest Renminbi and exit via IPO in China. So far so good. The Chinese government is also pouring huge sums of its own cash into private equity, either directly through state-owned companies and agencies, or indirectly through the country’s pay-as-you-go social security fund. (See my recent blog post here.)

Exact figures are hard to come by. But, it’s a safe bet that at least Rmb100 billion (USD$15 billion) in capital was committed to domestic private equity firms last year. This year should see even larger number of new domestic PE firms established, and even larger quadrants of capital poured in.

It’s going to be a few years yet before the successful Chinese domestic PE firms start returning significant investment profits to their investors. When they do, their investors will likely be in for something of an unpleasant surprise: the PE firms’ profits, almost certainly, will be reduced by as much as 25% because of income tax.

In other words, along with building a large homegrown PE industry that can rival those of the US and Europe, China is also determined to assess those domestic PE firms with sizable income taxes. These two policy priorities may turn out to be wholly incompatible. PE firms, more than most, have a deep, structural aversion to paying income tax on their profits. For one thing, doing so will cut dramatically into the personal profits earned by PE partners, lowering significantly the after-tax returns for these professionals. If so, the good ones will be tempted to move to Hong Kong to keep more of their share of the profits they earn investing others’ money. If so, then China could get deprived of some experienced and talented PE partners its young industry can ill afford to lose.

It’s still early days for the PE industry in China. Renminbi PE firms really only got started two years ago. I’ve yet to hear any partners of domestic PE firms complain. But, my guess is that the complaining will begin just as soon as these PE firms begin to have successful exits and begin to write very large checks to the Chinese tax bureau. What then?

China’s tax code is nothing if not fluid. New tax rules are announced and implemented on a weekly basis. Sometimes taxes go down. Most often lately, they go up.  Compared to developed countries, changing the tax code in China is simpler, speedier. So, if the Chinese government discovers that taxing PE firms is causing problems, it can reverse the policy rather quickly.

The PE firms will likely argue that taxing their profits will end up hurting hundreds of millions of ordinary Chinese whose pensions will be smaller because the PE firms’ gains are subject to tax. In industry, this is known as the “widows and orphans defense”. Chinese contribute a share of their paycheck to the state pension system, which then invests this amount on their behalf, including about 10% going to PE investment.

PE firms outside China are structured as offshore companies, with offices in places like London, New York and Hong Kong, but a tax presence in low- and no-tax domains. But, there’s currently no real way to do this in China, to raise, invest and earn Renminbi in an offshore entity. Changing that opens up an even larger can of worms, the current restrictions preventing most companies or individuals outside China from holding or investing Renminbi. This restriction plays a key part in China’s all-important Renminbi exchange rate policy, and management of the country’s nearly $2.8 trillion of foreign reserves.

The world’s major PE firms are excitedly now raising Renminbi funds. Several have already succeeded, including Carlyle and TPG. They want access to domestic investment opportunities as well as the high exit multiples on China’s stock market. When and if the income tax rules start to bite and the firm’s partners get a look at their diminished take, they may find the appeal of working and investing in China far less alluring.

 

 

 

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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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In Full Agreement

Leave a Comment / January 27, 2011

pyramid

I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.


What’s Behind China’s Reverse IPOs?


A dysfunctional financial system pushes companies toward awkward deals in America.
By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

US Government Acts to Police OTCBB IPOs and Reverse Mergers for Chinese Companies

1 Comment / January 5, 2011

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In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.


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CFC’s New Research Report, Assessing Some Key Differences in IPO Markets for Chinese Companies

Leave a Comment / December 7, 2010

China First Capital research report cover

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

  1. Valuation, p/e multiples
  2. IPO approval process – cost and timing of planning an IPO
  3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.


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ChiNext: One Year Later, Celebrating a Success

1 Comment / November 1, 2010

Zhou dynasty from China First Capital blog post

This past Saturday, October 30,  marked the one year anniversary of the founding of the ChiNext (创业板) stock market. In my view, the ChiNext has been a complete and unqualified success, and should be a source of pride and satisfaction to everyone involved in China’s financial industry. And yet, there’s quite a lot of complaining and grumbling going on, about high share prices, high p/e multiples,  “underperformance” by ChiNext companies, and the potentially destabilizing effect of insiders’ share sales when their 12-month lockup period ends.

Let’s look at the record. Over the last year, the board has grown from the original 28 companies to 134, and raised a total of 94.8 billion yuan ($14bn). For those 134 companies, as well as hundreds more now queuing up for their ChiNext IPO, this new stock market is the most important thing to ever happen in China’s capital markets.

Make no mistake, without the ChiNext, those 134 companies would be struggling to overcome a chronic shortage of growth capital. That Rmb 94.8 billion in funding has supported the creation of thousands of new jobs,  more indigenous R&D in China, and provided a new and powerful incentive system for entrepreneurs to improve their internal controls and accounting as a prelude to a planned ChiNext IPO.

China’s retail investors have responded with enthusiasm to the launch of ChiNext, and support those high p/e multiples of +50X at IPO. It is investors, after all, who bid up the price of ChiNext shares, and by doing so, allow private companies to raise more capital with less dilution. Again, that is a wholly positive development for entrepreneurship in China.

Will some investors lose money on their investments in ChiNext companies? Of course. That’s the way all stock markets work. The purpose of a stock market is not to give investors a “one way bet”. It is to allocate capital.

I was asked by a Bloomberg reporter this past week for my views on ChiNext. Here, according to his transcript,  is some of what I told him.

“For the first time ever, the flow of capital in China is beginning to more accurately mirror where the best growth opportunities are. ChiNext is an acknowledgement by the government of the vital importance of entrepreneurial business to China’s continued economic prosperity. ChiNext allocates growth capital to businesses that most need and deserve it, and helps address a long-standing problem in China’s economy: capital being mainly allocated to state-owned companies. The ChiNext is helping spur a huge increase of private equity capital now flowing to China’s private companies. Within a year my guess is the number of private equity firms and the capital they have to invest in China will both double.”

A market economy functions best when capital can flow to the companies that can earn the highest risk-adjusted return. This is what the ChiNext now makes possible.

Yes, financial theory would argue that ChiNext prices are “too high”, on a p/e basis. Sometimes share prices are “too high”, sometimes they are “too low”, as with many Chinese companies quoted on the Singapore stock market. A company’s share price does not always have a hard-wired correlation to the actual value and performance of the company. That’s why most good laoban seldom look at their share price. It has little, if anything, to do with the day-to-day issues of building a successful company.

Some of the large shareholders in ChiNext companies will likely begin selling their shares as soon as their lock-up period ends. For PE firms, the lock-up ends 12 months after an IPO. If a PE firm sells its shares, however, it doesn’t mean the company itself is going sour. PE firms exist to invest, wait for IPO, then sell and use that money to repay their investors, as well as invest in more companies. It’s the natural cycle of risk capital, and again, promotes overall capital efficiency.

There are people in China arguing that IPO rules should be tightened, to make sure all companies going public on ChiNext will continue to thrive after their IPO. That view is misplaced. For one thing, no one can predict the future performance of any business. But, in general, China’s capital market don’t need more regulations to govern the IPO process. China already has more onerous IPO regulations than any other major stock market in the world.

The objective of a stock market is to let  investors, not regulators, decide how much capital a company should be given.  If a company uses the capital well, its value will increase. If not, then its shares will certainly sink. This is a powerful incentive for ChiNext company management to work hard for their shareholders. The other reason: current rules prohibit the controlling shareholders of ChiNext companies from selling shares within the first three years of an IPO.

The ChiNext is not a path to quick riches for entrepreneurs in China. It is, instead, the most efficient way to raise the most capital at the lowest price to finance future growth. In the end, everyone in China benefits from this. The ChiNext is, quite simply,  a Chinese financial triumph.


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A Nominee For A PE Medal of Honor

Leave a Comment / October 31, 2010

medal

If they gave medals for valor and distinguished service to the PE industry, SAIF’s Ben Ng surely earned one this past week. In a twelve hour stretch, he met with the laoban (Chinese for “boss”) of four different Chinese SME, at four different company headquarters, and probed each on the merits of their particular business.

The companies were at four different stages, from start-up to a 14-year-old company with a household name in much of southern China, and from four very different industries, from robotic manufacturing to a major fast-food chain, from agriculture to e-commerce.

Ben never wavered, never tired, never lost his genuine enthusiasm for hearing great entrepreneurs talk about what makes their businesses special, while explaining a little about his own company. As I found out later, Ben left a deep imprint with each entrepreneur, and in his understated way, showed each of them why SAIF is such an outstanding success in the PE industry in China, SAIF has backed more than 80 companies during its 10 year history, with $3.5 billion under management, and some of the more illustrious Limited Partners of any PE firm in the world.

By the end of the day, Ben was still full of life, mind sharp and mood upbeat. I, on the other hand, had a case of “PE battle fatigue”. I got home and almost immediately crawled into bed, trying to recall, without much success, which laoban had said what, and which business model belonged to whom. I’ve met a lot of company bosses in my 25-year career. But, I can’t recall ever having so many meetings at this high level in one day. Ben, on the other hand, mentioned he has days like this quite often, as he travels around China.

Ben is a partner at SAIF, with long experience in both high-technology and PE investing. He’s one of the professionals I most like and respect in the PE industry in China. I wanted these four laoban to meet him, and learn for themselves what top PE firms look for, how they evaluate companies, and how they work with entrepreneurs to accelerate the growth and improve the performance of their portfolio companies up to the time of an IPO, and often beyond.

Every great company needs a great investor. That about sums up the purpose and goal of my work in China.

I’d met these four laoban before and knew their businesses fairly well. In my view, each has a realistic chance to become the clear leader in their industry in China, and within a few years, assuming they get PE capital to expand, a publicly-traded company with market cap above $1 billion.  If so, they will earn the PE investor a very significant return – most likely, in excess of 500%. In other words, in my view,  a PE firm could be quite lucky to invest in these companies.

Will SAIF invest in any of the four? Hard to say. They look at hundreds of companies every year, and because of their track record, can choose from some of the very best SME in China. SAIF has as good a record as any of the top PE firms in China. According to one of Ben’s partners at SAIF, the firm has an 80% compounded annual rate of return.

That’s about as good as they get in the PE industry. SAIF’s investors might consider nominating the firm for a medal as well.

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Qinghai Province – The Biggest Small Place in China

2 Comments / October 2, 2010

Taersi

In most things to do with China, the “law of big numbers” applies. A population of 1.4 billion mandates that. So, whether it’s the fact there are over 50 cities larger than Rome, provinces with populations larger than any European country, or that more of just about everything is sold every year in China than anywhere else, the reality of China’s huge population is always a hulking presence.

Except for Qinghai Province. Here, the numbers are so small Qinghai can seem like one of the Baltic States. The province is a little larger than France, yet has a population of only 5.2 million, or 0.3% of China’s total. The capital city, Xining, where I’m now writing this, has about one million residents. Tibet to the south and Xinjiang to the north are both autonomous regions, rather than provinces. Both are far more well-known and talked-about, both inside China and out, and benefit from much more investment from the central government.

Qinghai is unlike anywhere I’ve been in China. It is so empty as to be almost desolate. Xining is in the midst of a very rapid transformation from a dusty low-rise backwater to a more obviously modern Chinese city, with high rises, two new expressways, broad boulevards and shiny new shops selling brands familiar in other parts of the country. It sits alongside a tributary of the Yellow River, wedged like a sliver between low barren brown mountains.

Xining is also the most conspicuously multi-cultural city I’ve been to in China, with a Han majority sharing the city with a large contingent of Tibetans, and a very significant population of Hui Moslems. The Dongguan mosque, on the city’s main street, is one of the largest in China. As many as 30,000 people can worship there. Every twenty paces or so you’ll pass a small brazier with a Hui cook barbecuing lamb kebabs.  Most also sell yak milk yogurt. It’s delicious, in case you’re wondering.

The Tibetans are more concentrated outside Xining. Qinghai makes up most of the Tibetan region of Amdo, and much of the province’s landmass is inhabited by Tibetan herdsmen. The current Dalai Lama was born not far from Xining, and had some of his first schooling at Kumbum Monastery, a 450 year-old establishment that has long been among the most important sites of religious worship and study for Tibetan Buddhists.

Kumbum is a half-hour drive from Xining.  I’ve wanted to go there for about 30 years, and finally got the chance on this trip. I always felt a pull towards Kumbum because it was established to venerate Tsongkhapa, the founder of the Gelugpa tradition in Tibetan Buddhism. I’ve lived for the last 15 years with a beautiful thangka of Tsongkhapa, and hang it near where I sleep. Here it is:


Tsongkhapa

If I had a patron saint, it would be him. Tsongkhapa was born where the Monastery now sits, in a small mountain village. The Monastery spreads lengthwise about one mile up a hillside. At its height, it was home to 3,600 monks. Now there are said to be about 500. A lot of the more ancient buildings were destroyed during the Cultural Revolution, and have since been rebuilt. There are also some newer structures in traditional Tibetan monastic style, including one built with a donation from Hong Kong’s richest man, Li Ka-shing.

Tibetan pilgrims circumambulate the important buildings, do their prostrations, and leave offerings of money and butter. They share Kumbum with Chinese tour groups, who are for the most part respectful, attentive.

After visiting the Monastery in a steady drizzle, I went to see a doctor at the nearby hospital. I was feeling just fine, but for a little sleepiness from the high altitude.  I’ve had a long, intense interest in Tibetan medicine, and the hospital here is staffed by lamas educated at Kumbum and graduated with the equivalent of a PhD in Tibetan medicine.

I saw a physician named Lopsang Chunpai, dressed in maroon and yellow monastic robes. He took my pulse, pronounced me healthy, and prescribed a Tibetan herbal medicine called Ratna Sampil, a combination of 70 herbs that is compounded at the hospital. According to the package, it’s used “clearing and activating the channels and collaterals”.

Though I saw only a very small part of it, Qinghai struck me as an especially lovely place:  a wide, open and arid plateau not unlike parts of the American West. Even accepting the cold winter (with temperatures of 20 to 30 degrees below zero centigrade), it’s hard to understand the high vacancy rate here. It’s population density, at 7 people per square kilometer, is 0.3% of Shanghai’s.

It’s empty, of course, because comparatively few Chinese have emigrated here. That seems likely to change. The air is clean, the economy is booming and the infrastructure improvements of recent years are integrating the province much more closely with the highly-populated parts of China to the east.

Neighboring Tibet and Xinjiang have experienced large Han Chinese migration over the last 60 years. Not so Qinghai. Geography is destiny.  Qinghai, unlike Xinjiang and Tibet, does not border any other country. It has far less military and strategic importance. Xinjiang borders Russia and Tibet borders India. China has fought border wars with both.

Xinjiang and Tibet have also both recently had some serious ethnic conflicts, including anti-Chinese riots in both places in the last two years.  Although its population is about 20% Moslem and 20% Tibetan, Qinghai has stayed peaceful. It is China’s melting pot.

Qinghai is rich in mineral resources, including large seams of high-grade coal. As the transport system improves, more Chinese will migrate there to work in mines. Xining, as small as it is, is the only proper city in all of Qinghai.

The ostensible reason for my visit was to speak at a conference on private equity. The provincial government has a target to increase the number of Qinghai companies going public. The mayor of Xining, who I met briefly, was until recently a successful businessman, running one of the province’s largest state-run companies.

I met a few local entrepreneurs and visited one factory making wine from buckthorn berries, using technology developed by Tsinghua University. It’s a healthier, lower-proof alternative to China’s lethal “baijiu”, the highly alcoholic spirit, mainly distilled from sorghum,  that is widely consumed across China.

Up to now, as far as I can tell,  there’s been no private equity investment in Qinghai. I’d like to change that. It’s a special part of China. Though it’s statistically one of the poorest provinces, Qinghai will continue every year to close the gap. More capital, more opportunity, more prosperity — and more inhabitants. This is Qinghai’s certain future.


LEDs in China – Hope vs. Hype

1 Comment / September 15, 2010

Qing dynasty cloisonne lanterns

Can a technology invented in the US by General Electric 48 years ago give China its best shot at worldwide technological leadership? There are a lot of Chinese companies, entrepreneurs, investors, as well as billions of dollars in Chinese government money betting this is the case.

The technology is the Light Emitting Diode, or LED. Since their invention a half-century ago in Syracuse, New York, lots of otherwise smart people have been predicting LEDs would replace the traditional incandescent lights perfected by Thomas Edison well over a century ago as a primary source of illumination.

LEDs have numerous advantages – the key ones being they last longer than traditional incandescent and neon bulbs and use much less energy to produce the same amount of light.

In other words, LED sound like a sure thing. Problem is, they are almost as tricky to manufacture as integrated circuits, and so exponentially more expensive to produce than conventional bulbs. LED technology has improved dramatically over the years, but they are solid-state devices, made using a complicated semiconductor-layering technique.

The lights require lots of complex circuitry and heat sinks, and are very susceptible to changes in temperature. Each individual LED is about the size of a Christmas light, and produces a relatively small amount of light. So, an LED  with the same output of a typical street light will actually have dozens of small LEDs pinched together on a single stalk.

Like the non-polluting 500-mile-per-gallon auto engine and supersonic passenger jets, the era of universal, efficient, energy-saving LED lighting is another much-predicted part of our future that never seems to arrive.

Except, that is, in China. Here, there is abundant optimism that the commercial market for LED lighting is about to explode, and that Chinese companies will be the worldwide leaders in a new multi-billion-dollar industry.

There are more LED companies in China, and more investment flowing into them, than anywhere else in the world. On Alibaba.com, there are about two million Chinese companies selling LED products, a hundred times more than Taiwanese companies offering LED products. In Shenzhen where I live, there are 280,000 companies listed on Alibaba offering LED lamps and bulbs.

Last year, I went to one of the main trade shows for the industry in China, and hundreds of companies were crowded into the exhibition space. The majority of them were offering LED street and traffic lights, and systems to control them.

Looking at this, you’d imagine that just about every busy intersection in China was already controlled by an LED traffic light. That isn’t so today. Though the technology is well-developed, LED traffic lights are still very rare. But, the Chinese government is looking to spend a great deal of money to make this a reality. This, in turn, is drawing companies into the industry at an ever-increasing clip.

One small measure of this enthusiasm. The bosses of two companies we work with, including one that’s a leader in the jewelry industry,  are now investing in LED street lighting projects. Lots of the venture capital and private equity firms we work with are eager to invest in China’s LED industry.

There are those outside China who share some of this optimism about LED’s future. But, nowhere else is the fever quite as widespread as it is here.

To be successful in the LED industry will require a synthesis of advanced scale manufacturing techniques and some sophisticated technological skills and innovative science. In other words, China has the two essential elements for success.

However, good science and good factories won’t solve the primary problem that LED lights remain uneconomic for most users. Even with the energy savings and longer life, the typical payback period for an LED is eight to ten years. Of course, some of the greenest of environmentally-conscious green buyers will pay that kind of premium.  But, the reality is there just aren’t that many businesses or households that will invest in LEDs when they need to wait so long just to breakeven compared to conventional incandescents.

That leaves only government as a likely big customer. No other government is quite as keen on LEDs as China’s. From the central government on down, there are plans in place now to replace all conventional street lights with LEDs.  In theory, this represents a market worth many billions of dollars. The millions of LED companies in China all seem to be chasing this one market.

Governments everywhere, not just in China, tend to be far less persuaded than private businesses by the logic of a cost-benefit analysis. China’s government wants to cut energy use and wants to foster the domestic LED industry. If successful, the large-scale government purchases in China would drive down manufacturing costs to the point where LEDs become cost-competitive everywhere. If so, China’s LED industry will truly become both world-beating and gargantuan in size.

I’ve yet to see a single LED street light in China. I have seen working prototypes, and they seem quite good. When big government orders will arrive and who will receive them remain collective guesswork in the Chinese LED industry.

That sums up precisely the dilemma of the LED industry. The companies are all reliant on a single, large and very unpredictable customer. When that one customer is government, equally large problems invariably intrude. Government purchases in China, as in the US and elsewhere, are slow to materialize, highly bureaucratic and favor companies with friends in high places, rather than those with the best products.

Buying from the lowest-cost supplier is often less important than buying from friends and cohorts. Basic LED technology is already very well-established and lots of companies can make the lights. The result: the government cash will likely get spread around widely, to thousands of small local firms. If this happens, the risk is that no one Chinese firm develops the scale economies to become truly efficient, and a potential global leader.

For LED lights to realize the huge potential first glimpsed when they were invented 50 years ago, they need to come down very dramatically in cost, to levels at least comparable with compact fluorescents. These CFL bulbs last eight to fifteen times longer than incandescents, and use only 30% as much energy. Their payback period is much quicker than LEDs, and they are already quite pervasive in homes and offices.

China has a chance to take the lead and take LED lighting to another level. I love all the excitement and entrepreneurial activity in the industry. Hope or hype, we’re likely to find out in the next three to five years.


How PE Firms Can Add – or Subtract – Value: the New CFC Research Report

1 Comment / August 8, 2010

China First Capital research report

CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report. 

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. 

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 same”. 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. 

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. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. 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. 

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? 

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. 

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. 

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 investors”.

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.   

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.

chart1

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. 

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. 

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. 

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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