China Private Equity

Navigating China’s Treacherous IPO Markets

Leave a Comment / January 11, 2010

Song plate from China First Capital blog post

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  


The End of the Line for Old-Style PE Investing in China

2 Comments / January 4, 2010

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

chart1









If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.


Not Accountable: Why Brilliant 15th-Century Italian Accounting Rules Are Sometimes of Limited Use in China

Leave a Comment / December 21, 2009

 

Luca Pacioli

Luca Pacioli

 

In the history of business, there are no innovations more important, transformative, valuable and widely-used than Luca Pacioli’s. Yet, few know his name. He never made a fortune and likely spent most of his adult life in prayer and cloistered meditation. 

Pacioli was a 15th century Italian mathematician and monk who first codified the system of double-entry bookkeeping. This made modern corporate management possible, by providing a standardized and generally foolproof system for summarizing a business’s financial condition. Pacioli’s system of offsetting credits and debits remains very much the basis of all modern corporate accounting. 

I looked around, but couldn’t discover when double-entry bookkeeping, Pacioli’s brainchild, was first introduced to China. It is certainly pervasive now. The principles of corporate accounting, like mathematics,  don’t change as you move across national borders. In private equity investing, the process of assessing a company’s performance and attractiveness as an investment will be a function, ultimately, of its profitability and net asset value. Pacioli’s methods are the tools to determine both. 

Yet, there are times when I think Pacioli’s accounting principles are no more useful a tool in private equity investment in China than his fellow Italian Marco Polo’s travelogues are to current-day tourists visiting the Great Wall. They are better than nothing. But, you will still need to do a lot of your own strenuous legwork. 

The reason is that accounting principles are not widely applied in the management of many of the better private SME in China. They are entrepreneur-led businesses. Usually the most complete statement of the businesses financial worth is not to be found on a company balance sheet, but in the mind  of the entrepreneur. Some of this is by habit, other by design, to thwart any unwanted outsider, especially the taxman, from knowing exactly what is going on in a company. 

One example from my own work: I made a first visit to an excellent company, with a thriving retail business and brand that’s both well-established and well-known in large parts of China. I was immediately impressed and asked the finance director for the company’s last year’s revenues and profits. “I don’t know,” she replied. Quickly, it became clear she wasn’t being coy or secretive. She genuinely did not know. “Only the boss knows”, she explained, looking over at him. 

He looked momentarily baffled, as if the question had never been posed before, and then did the calculation aloud. He knew precisely how many products he manufactured last year, the average selling price, and unit profit. So with a little multiplication, we were able to get to a number. Turned out, revenues were well north of USD$65mn, and net profits over $7mn. Very solid numbers. We later brought in an accounting firm to do a trial set of financials, and in fact, the true figures were about 15% higher than that first calculation by the boss. Apparently, he hadn’t fully consolidated the results from an outsourced production facility. 

It’s a great company from every perspective – except if you’re trying to evaluate it quickly, using a statement prepared using Luca Pacioli’s principles. Anyone attempting to assess the company using such methods is going to hit a wall, right at the outset. 

The company, like many others of China’s best private firms, does not track its performance with a set of financials, or commission an annual audit. Management stays rigorously attuned to operational details, to cash in the bank, to inputs and outputs, to seizing any available economies to fatten its profit margin. Most often, none of this is ever summarized in a P&L or balance sheet. The boss doesn’t need it. He lives and breathes it every day. 

Any PE firm looking to evaluate the company needs to do the same  – spend time at the company, with the boss, in the factory, and get a feel for how the business is running. If you make it a precondition before any visit to have a set of financials, you’re going to be spending a lot of time anchored to your desk, or visiting only companies that are so hard-up for cash that they’ve spent a good chunk of money getting financials done, to please potential investors. Even in China, an audit done by a local Chinese accounting firm can cost well over USD$50,000. I’d rather have that money spent where it can do more good, like building the business.  

Some good private Chinese companies do have audited financials. They are usually the ones with sizable bank loans. An annual audit is often a covenant of such loans. But, in my experience, most good Chinese companies, with little or no debt and no urgent need to attract investors will not have the sort of financials that some PE firms want to see at the start. 

In China, a set of financials should not be an absolute prerequisite for PE investors. The first step should be to understand the business operationally, and then pay a visit, if the industry and business model both seem attractive. You learn more in two hour site-visit than you would in two days combing through financials.  Besides, any PE firm will commission its own audit, usually by a Big Four accounting firm, before it invests, during the due diligence phase. So, no one is committing money blindly. Eventually, Luca Pacioli’s principles will be put to work. The only issue is whether this is a first step, or one that comes later in the process. 

Accounting rules have enormous value.  Double-entry bookkeeping has never been improved upon, in the 500 years since Pacioli wrote the rules. But, in private equity investment in China, an over-reliance on financial statements, especially as a first-step in getting to know a company, will distort more often than it clarifies. As brilliant as he was, Luca Pacioli could not have anticipated the singular conditions and management style of the current generation of China’s successful private entrepreneurs. 


Will Bad Money Drive Out Good in Chinese Private Equity?

2 Comments / December 1, 2009

Qing Dynasty jade boulder, from China First Capital blog post

The financial rule first postulated by Sir Thomas Gresham 500 years ago famously holds that “bad money drives out good”. In other words, if two different currencies are circulating together, the “bad” one will be used more frequently. By “bad”, what Gresham meant was a currency of equal face value but lower real value than its competitor. A simple way to understand it: if you had two $100 bills in your wallet, and suspected one is counterfeit and the other genuine, you’d likely try to spend the counterfeit $100 bill first, hoping you can pass it off at its nominal value. 

While it’s a bit of a stretch from Sir Thomas’s original precept, it’s possible to see a modified version of Gresham’s Law beginning to emerge in the private equity industry in China. How so? Money from some of “bad” PE investors may drive out money from “good” PE investors. If this happens, it could result in companies growing less strongly, less solidly and, ultimately, having less successful IPOs. 

Good money belongs to the PE investors who have the experience, temperament, patience, connections, managerial knowledge and financial techniques to help a company after it receives investment. Bad money, on the other hand, comes from private equity and other investment firms that either cannot or will not do much to help the companies it invests in. Instead, it pushes for the earliest possible IPO. 

Good money can be transformational for a company, putting it on a better pathway financially, operationally and strategically. We see it all the time in our work: a good PE investor will usually lift a company’s performance, and help implement long-term improvements. They do it by having operational experience of their own, running companies, and also knowing who to bring in to tighten up things like financial controls and inventory management. 

You only need to look at some of China’s most successful private businesses, before and after they received pre-IPO PE finance, to see how effective this “good money” can be. Baidu, Suntech, Focus Media, Belle and a host of the other most successful fully-private companies on the stock market had pre-IPO PE investment. After the PE firms invested, up to the time of IPO, these companies showed significant improvements in operating and financial performance. 

The problem the “good money” PEs face in China is that they are being squeezed out by other investors who will invest at higher valuations, more quickly and with less time and money spent on due diligence. All money spends the same, of course. So, from the perspective of many company bosses, these firms offering “bad money” have a lot going for them. They pay more, intrude less, demand little. Sure, they don’t have the experience or inclination to get involved improving a company’s operations. But, many bosses see that also as a plus. They are usually, rightly or wrongly,  pretty sure of themselves and the direction they are moving. The “good money” PE firms can be seen as nosy and meddlesome. The “bad money” guys as trusting and fully-supportive. 

Every week, new private equity companies are being formed to invest in China – with billions of renminbi in capital from government departments, banks, state-owned companies, rich individuals. “Stampede” isn’t too strong a word. The reason is simple: investing in private Chinese companies, ahead of their eventual IPOs, can be a very good way to make money. It also looks (deceptively) easy: you find a decent company, buy their shares at ten times this year’s earnings, hold for a few years while profits increase, and then sell your shares in an IPO on the Shanghai or Shenzhen stock markets for thirty times earnings. 

The management of these firms often have very different backgrounds (and pay structures) than the partners at the global PE firms. Many are former stockbrokers or accountants, have never run companies, nor do they know what to do to turn around an investment that goes wrong. They do know how to ride a favorable wave – and that wave is China’s booming domestic economy, and high profit growth at lots of private Chinese companies. 

Having both served on boards and run companies with outside directors and investors, I am a big believer in their importance. Having a smart, experienced, active, hands-on minority investor is often a real boon. In the best cases, the minority investors can more than make up for any value they extract (by driving a hard bargain when buying the shares) by introducing more rigorous financial controls, strategic planning and corporate governance. The best proof of this: private companies with pre-IPO investment from a “good money” PE firm tend to get higher valuations, and better underwriters, at the time of their initial public offering. 

But, the precise dollar value of “good money” investment is hard to measure. It’s easy enough for a “bad money” PE firm to claim it’s very knowledgeable about the best way to structure the company ahead of an IPO.  So, then it comes back to: who is willing to pay the highest price, act the quickest, do the most perfunctory due diligence and attach the fewest punitive terms (no ratchets or anti-dilution measures) in their investment contracts. In PE in China, bad money drives out the good, because it drives faster and looser.

Multi-Tasking, Chinese Style

1 Comment / November 24, 2009

China First Capital blog post -- Qing Dynasty grissaille stype

For 18 months or so,  until last month, I tried burning my work candle at both ends. The goal was to play a constructive role both as Chairman of China First Capital, and CEO of Awareness Technologies. For me, it’s been something of a dream come true, this chance to work with two great companies, at different points in their lifecycle, in wholly different industries, with different home markets, different customers, different languages, and vastly different business models.  So much the better. 

It’s also exposed, in way that nothing else ever quite has, just how limited my managerial skills are. They are, at best, barely adequate for managing one business. Cleaved in two, they are woe-begotten. It probably also helps explain why bigamy never really caught on. Attention divided is attention corrupted. 

Or so I thought, until I began spending time with one supremely talented entrepreneur in China. He’s the boss of at least four different companies. There could be more, for all I know. Each time we meet, he mentions, in passing, another business that he founded and runs. Other than the fact they’re all based in China, they are all as different from one another as chalk and cheese. This entrepreneur owns and manages a very consumer goods company, a mining business, an advertising agency and a high-technology business.

And when I say “manage”, I mean manage. He’s not some absentee landlord. He spends significant time with each, and established each to seize what is a very large market opportunity. I only know in detail one of these companies, and it’s outstanding. My sense is that the others are no less so. 

So, how does this one guy do it? For one thing, he’s probably a lot smarter, and certainly more locked-in and ambitious than I am. He sees the world, so far as I can tell, as a vast and intricate delta, of multiple earning streams and innumerable opportunities for profit. He grabs only those that he knows he can readily seize – by being clearer, smarter, and richer than any competitor. 

Me, I look in my business life more for purpose than for profit, for the chance to work on large and complex problems, rather than ways to make a killing. It’s probably why I’ll never be as rich, or as managerially capable, as this Chinese businessman. Some businessmen enter new areas for the very sound reason of diversifying their sources of wealth.

This businessman does so because he visualizes the world as a series of P&L statements. He sees (better than anyone I’ve ever met) where the money is. Then he goes for it. He also chooses businesses that let him maximize his managerial skills, by setting a concrete direction, funneling in the capital, hiring strong management, and then waiting for the money to flow. 

Knowing him more and more, I’m convinced he’d never have entered the two businesses I’m now involved with: investment banking and enterprise software. Investment banking, especially for Chinese SME,  has too many moving parts, too many vagaries (for example, of market prices and investor predilections); enterprise software is crowded, and competitive, prone to technological disruption,  and has many smart people chasing the same limited supply of dollars. 

As I said, I like challenge. He likes making money. 

The kicker here is that it turns out, we need each other. I need him, because my investment banking business thrives by having the very best Chinese entrepreneurs as clients. He needs me to help him get additional capital to build the most promising of his businesses. I am equally confident we can get him that capital as I am that he will put it to very productive use, and so earn his investor a fortune. 

Of all the entrepreneurs I work with, this guy is the one that I’m most awed by, probably because he is so obviously so much better at this “CEO multi-tasking” than I am. He is very comfortable in his skin, and clearly having a great time in life.  It’s a joy to be a small part of his intricate, expansive and beautifully-engineered business empire.

Why Is China Booming? Surprise, It’s Not the Stimulus

1 Comment / November 13, 2009

China First Capital blog post -- Qing Dynasty stupa

Launched amid much worldwide rejoicing when the financial crisis struck last year, China’s Rmb 4 trillion ($585 billion) stimulus package is given much of the credit for China’s continued strong economic performance this year. China’s GDP growth is likely to exceed 8%, and the domestic stock market is up by over 70% since the start of the year. 

A Keynesian miracle? To read a lot of the financial commentary on China, you might well conclude this is so, that government spending has single-handedly kept the economy jaunty, while both firms and consumers sank into a deep funk. It’s a great story, and provides a simple explanation for how China dodged the bullets that struck all other major economies. Other countries looked on enviously, and urged China to continue the fiscal pump-priming to help out the overall world economy. 

Problem is, the analysis is flawed. China’s stimulus plan is not all it’s cracked up to be. While the additional government spending has clearly played a part, it is not the only reason why China’s economy has remained so sound this year. The unsung heroes of China’s economic success this year are its ordinary consumers. It’s their continued confidence and increased spending that have really made the difference. 

Economic statistics are notoriously iffy in China. The further one gets from the economic lever-pullers in Beijing, the harder it becomes to track economic activity. That’s another reason why the stimulus plan was so often singled out as the main spur to China’s growth. It’s easier to calculate how much additional the Chinese government is spending building expressways than it is to see how many pairs of socks or bowls of noodles Chinese are buying. 

Another reason: a lot of the economic commentary comes from folks who believe that governments really are responsible for what happens, good and bad, in an economy. Again, it’s just so much simpler to view things this way, that powerful government men can pull out their checkbooks and spend their way to national prosperity. These are often the same people who will tell you, wrongly, that Roosevelt’s New Deal spending lifted the US out of Depression.

China’s supporters and detractors both give the government too much credit. There are those who are convinced China’s economic growth is all some kind of fraud, cooked up by the central government, and that once the extra government spending is dialed down, the economy is certain to crash. 

Again, pure hogwash. 

In China, the government rightly deserves credit for excellent economic management, for creating the circumstances, both marco and micro,  that allow the Chinese economy to continue to thrive. I’ve said it frequently, including in public forums: China is the best-managed major economy in the world. 

But, again, let’s also commend the country’s one-billion-plus consumers, too often seem as miserly skinflints, saving up all their money for their great-grandchildren’s rainy days. It just ain’t so. China’s consumers, with an ever-increasing choice of products, services and shops, are spending ever-increasing sums on improving the quality of their lives. Newer and better housing. New cars. Holidays. New wardrobes. You name it. 

I see it every day here, the untethered exuberance of the Chinese consumer. It’s true that in the early part of this year, there was a relative lull. Back then, shops were working harder to attract customers, by putting a lot of their goods on sale at steep discounts. About four months ago, the situation began to change markedly. No more major knockdowns. Prices now all seem to carry list price, and the prices for many common consumer products are as high, or higher, than in the US. 

Not much of this, it goes without saying, gets noticed by the world’s financial commentariat. Car sales in China are at an all-time high, and China is now the world’s largest car market. But, listen to the commentators, and they’ll tell you it’s the result of some small government tax breaks on new car purchases. Helpful, yes. The main spur? No. Car prices in China are still, in dollar terms, generally much higher than in the US. Based on a percentage of average disposable income, car prices in China are probably among the most expensive in the world. Same goes for property prices. Yet, Chinese keep buying. 

They will keep buying, at or near this record pace, long after any tax breaks phase out.  Chinese want the new cars to drive on the new expressways to carry them to the new shopping malls to buy the new furniture for their new apartments. 

Of all the economic statistics I’ve seen lately, the one that best captures what is going on now in China is this: revenues in China’s restaurant industry were up 18% during the first half of 2009, to over $120 billion. That’s not due to stimulus, or bank loans, or tax concessions, or a government mandate to entertain more. It’s largely because Chinese are out having a good time, more often, and spending a lot more doing so than they did a year ago. 

It’s one of the best barometers of a nation’s mood, restaurant spending. In China, the mood is buoyant, the outlook bright, and the woks are working overtime.

 


 

International Investors Miss The Boat in China – Because They’re Not Allowed Onboard

Leave a Comment / October 31, 2009

China First Capital blog post Ming jar

Despite my fourteen years living in London,  I needed to fly all the way back to that city this week, from China, to finally get a look at Westminster Central Hall, a stately stone pile across the street from the even statelier, stonier pile that is Westminster Abbey. Central Hall does double duty, both as a main meeting place for British Methodists, and also as an impressive venue for conferences, including the first meeting of the United Nations in 1946. 

This week, it was site of the annual Boao Forum for Asia International Capital Conference. I flew in to attend, and participate in a panel discussion on private equity in China. The Boao Forum is something like the more renowned Davos Forum, but with a particular focus on Asia and China. This annual meeting focused on finance and capital, and drew a large contingent of about 120 Chinese officials and businesspeople, along with an equal number of Western commercial bankers, lawyers, accountants, investors, politicians, academics and a few other investment bankers besides me. 

Central Hall is crowned by a large domed ceiling, said to be the second-largest in the world. I enjoyed sending back a brief live video feed to my China First Capital colleagues in Shenzhen, whirling my laptop camera up towards the dome, and then down to show the conference. It was also the first time any of my colleagues had seen me in a suit. 

The weather was a perfect encapsulation of British autumn climate, with blustery and frigid winds, occasional radiant sunshine and torrential rain. It was my first trip back to London in over two years, and nothing much had changed. What a contrast to China, where in two years, most major cities seem to undergo a radical facelift. 

“How can a non-Chinese invest in Chinese private company?” It was a straightforward question, by a London-based money manager, for the panel I was on. Straightforward, even obvious, but it was actually one I’d never really considered before, to my embarrassment. In my talk (see Powerpoint here: http://www.chinafirstcapital.com/blog/wp-content/uploads/2009/08/trends-in-private-equity.pdf) , I made the case about why Chinese SME are among the world’s best investment opportunities for private equity firms.  It’s an argument I’m used to making to conference audiences in China. This is the first time I’ve done so anywhere else. The question, though, made me feel a bit like a guy telling his friends about the new Porsche Carrera for sale for $8,000, but then saying, “unfortunately, you’re not allowed to buy one.” 

The reality is that it’s effectively impossible for a non-Chinese investor, other than the PE firms we regularly work with,  to buy into a great private Chinese SME. For one thing, the investor would need renminbi to do so, and there’s no legal way to obtain it, for purposes like this. Even if you found a way around that problem, you’d face an even steeper one when you wanted to exit the investment and convert your profits back into dollars or sterling. 

The money manager came up to me later, and I could see the vexation in her eyes. I had persuaded her there were great ways for investors to make money investing in SME in China. Disappointingly, her clients aren’t allowed to do so. Cold comfort was all I could offer,  pointing out the same basic problem exists for any non-Chinese seeking to buy shares quoted on the Shenzhen and Shanghai stock markets. 

It’s a reasonable bet that China eventually will liberalize its exchange rate controls and ultimately allow freer convertibility of the renminbi. But, that doesn’t exist now. As a result, financial investment in renminbi in China is, for the most part, reserved exclusively for Chinese. Unfair? It must seem that way to the sophisticated, well-paid money managers in London, who these days have few, if any,  similarly “sure fire” investment options for their clients. 

China is, itself, awash in liquidity, and sitting on a hoard of over $2 trillion in foreign exchange reserves. So, there really is no shortage of capital domestically. Allowing foreign investors in, of course, would increase the capital available to finance the growth of great companies. But,  it will also add to the mountain of foreign reserves and put more upward pressure on the renminbi. That’s the last thing Chinese authorities need at the moment. So, most of the best investment opportunities in China are likely to remain, for quite a lot longer, open only to Chinese investors. 

Overall, this is a very good time to be Chinese. By my historical reckoning, it’s the best since at least the Tang Dynasty over 1,000 years ago. China has changed out of all recognition over the last 30 years, creating enormous material and social gains. That beneficial change, if anything, is accelerating. The fact Chinese also have some of the world’s best investment opportunities to themselves is just another dividend from all this positive change. 

If I were a money manager, I’d also be asking myself “how can I get some of this?” But, I’m not a money manager, and I formulate things very differently. I’m so happy and privileged to have a chance to help some of China’s great private entrepreneurs. Me and my team invest all our waking hours and all our collective passion in this. We are rewarded daily, by the trust put in us by these entrepreneurs, and by our very small contribution to their continued success. That’s more than adequate return for me.

I guess I’m not cut out for purely financial investing. 

 

No Preference: Disallowing Preferred Shares for Private Companies is Hobbling China’s Venture Capital and Private Equity Industry

Leave a Comment / October 31, 2009

 

Ming Dynasty mother-of-pearl from China First Capital blog post

Chinese securities regulations do not allow private domestic companies to issue preferred shares.  It does not sound particularly problematic, since preferred shares are not all that common anywhere. And yet, this regulatory quirk has serious unintended consequences. It is holding back the flow of private equity and venture capital investment into promising Chinese companies, particularly those with more than one shareholder. 

Preferred shares earn their name for a reason. These shares enjoy certain preferences over common shares, most often greater voting power and better protection in the event of bankruptcy. Preferred shares are the main mechanism through which venture capital and private equity firms invest in private companies. In general, when a PE or VC firm invests, the company receiving the investment creates a special class of preferred shares for the PE or VC. These preferred shares will have a raft of special privileges, above and beyond voting rights and liquidation preference. The theory is, the preferred shares level the playing field, giving the PE or VC firm more power to control the actions of the company, particularly how it uses the VC money,  and so protect its illiquid investment. 

Take away the ability to issue preferred, as is the case in China, and things begin to get much trickier for PE and VC investment. PE and VC firms are loathe to invest in ordinary common shares, since this gives them little of the protection they need to fulfill properly their fiduciary duty to their Limited Partners. There are, of course, all kinds of clever solutions that can be and often are employed to get around this problem in China. For example, the PE or VC firm can ask their very clever lawyers to craft a special shareholders agreement, to be signed by the company it’s investing in, that gives the PE or VC firm the same special treatment conferred by preferred shares. 

The problem here, though, is the legal enforceability of a shareholder agreement is not cut-and-dried.  A basis of most securities law, in China and elsewhere, is that all shareholders holding the same class of shares must be treated equally. In other words, if a PE or VC firm has ordinary common shares, it can’t get better treatment and more rights than any other common shareholder. 

What happens if a PE or VC firm’s shareholder agreement conflicts with this principle of equal treatment? China’s legal system is evolving, and precedent is not unequivocally clear. But, in general, the law takes precedence over any contract. In other words, if it comes down to a court fight, the PE or VC firm might find its shareholders agreement invalidated. 

This is not some remote likelihood, particularly if the company has more than just the founder and the PE or VC firm as shareholders. The “unpreferred” common shareholders have every right and many reasons to feel disadvantaged if they are deprived the same rights enjoyed by a VC firm also holding common shares.

There are many scenarios when this could lead to litigation, not just if the company runs into trouble, and shareholders end up fighting over how to divide whatever assets remain There’s also a big chance of legal mischief if the company does splendidly well. Let’s say the company is preparing for an IPO, and a shareholders agreement gives the VC firm special rights to have their shares registered and fully tradeable. This is a fairly common element in shareholders agreements. Other common shareholders would have ample reason to object, if their shares can’t be liquidated at the same time.  

Sometimes in business, legal uncertainty can be useful In this case, though, there are no clear winners. Anything that makes PE or VC firms less likely to invest disrupts the flow of capital to worthy businesses. That’s the situation now in China, with preferred shares disallowed and much uncertainty surrounding the legality of shareholders agreements. 

I have no special insight into why Chinese regulators have outlawed preferred shares for private domestic companies, or whether they are contemplating a change. But, a change would be beneficial. Most likely, the prohibition of preferred shares was designed to stop private companies from fleecing their unsuspecting equity-holders. In other words, the motive is sound. But, if the result is less growth capital available for successful young Chinese companies, the medicine ends up occasionally killing the patient. That doesn’t serve anyone’s interests: not entrepreneurs, nor investors, nor the country as a whole. 

 There are ways to give common shareholders some protection while still allowing private companies to create preferred shares. Ultimately, these common shareholders will likely benefit from the injection of PE or VC money into a company they’ve also invested in.  A shortage of capital is always a problem for growing companies, but it’s a particularly acute one in China. The PE or VC firm will also usually play a much more active role than other shareholders in building value, giving these other shareholders a free ride. 

Like most, I invest to make money, not exercise voting rights. So, my preference as a common shareholder will be to let the preferred have whatever rights they deem important – as long as they are doing the heavy lifting and pushing hard to build profits. They bring the capital, track record and expertise that often makes all the difference between a successful company and a has-been. I prefer to invest for success, and that often means preferring the presence of preferred investors.

China Zigs While the Rest of the PE and VC World Zags

Leave a Comment / September 10, 2009

Tang vase from China First Capital blog post

This is a time of darkness and despair for most private equity and venture capital guys. Their world came crumbling down last year, as credit and stock markets collapsed and IPO activity came to a halt everywhere —  everywhere that is, except China.  

If ever there were an example of a counter-cyclical trend, it is the private equity industry in China. It is poised now for the most active period, over the next 12 months, in its young history. There are many reasons to explain why China should be so insulated from the deep freeze that’s gripping the industry elsewhere. For one thing, it has always relied less on leverage, and more on plain vanilla equity investing. 

This mattered crucially, since as credit markets seized up last year, PE firms were still able to do deals in China, by putting their own equity to work. Of course, PE firms in the US could have done the same thing. After all, most have very large piles of equity capital raised from limited partners. But, they have habituated themselves to a different form of investing, involving tiny slivers of equity and very large slabs of bank debt. Like any leveraged transaction, it can produce phenomenal results, on a return-on-equity basis. But, without access to the debt component, many PE firms seem adrift. It’s as if they’ve forgotten, or lost the knack of how to properly evaluate a company, to look at cash flows not in relation to potential debt service, but as a telltale sign of overall operating performance. 

Many PE firms these days seem to resemble a hedge fund gone bad:  they once had a formula for making great piles of money. Then, markets changed, the formula stopped working, and the firms are at a loss as to how to proceed. 

China looks very different. Beyond the lack of leverage, there are other, larger factors at work that are the envy of the rest of the PE world. Most importantly, China’s economy remains robust. It’s done a remarkable pirouette, while the rest of the world was falling flat on its face. An economy dependent until recently on exports is now chugging along based on domestic demand. And no, it’s not simply — or even mainly —  because of China’s huge +$600 billion stimulus package. The growth is also fueled by Chinese consumers, who are continuing to spend. 

There’s one other key factor, in my opinion, that sets China apart and makes it the most dynamic and desirable market for PE investing in the world: the rise of world-class private companies, of a sufficient scale and market presence to grow into billion-dollar companies. In other words, PE investing in China is not an exercise in financial engineering. It’s straight-up equity investing into very solid businesses, with very bright futures. 

One common characteristic of PE investing in China, all but absent in the US, is that the first round of equity investment going into a company is smaller than trailing revenues. So, in a typical deal, $10mn will be invested into a company with $50 million of last year’s revenues, and profits of around $5 million. Risk mitigation doesn’t get much better than this: investing into established, profitable companies that are often already market leaders — and doing so at reasonable price-earnings multiples. 

China has other things going for it, from the perspective of PE investors: the IPO window is open; dollar-based investors have the likely prospect of upping their gains through Renminbi appreciation; management and financial systems both have significant room for improvement with a little coaching from a good PE firm. 

It all adds up to a unique set of circumstances for PE investors in China.  It’s a highly positive picture all but unrecognizable to PE and VC firms in the US and elsewhere. Opportunities abound. Risk-adjusted returns in China are higher, I’d argue, than anywhere else in the world. A +300% return over three to five years is a realistic target for most PE investment in China. The PE firms invest at eight times last year’s earnings, and should exit at IPO at 15 times, at a minimum. Pick the right company (and it’s not all that difficult to do so), and the capital will be used efficiently enough to double profits over  the term, between the PE investment and the IPO.  Couple these two forces together — valuation differentials and decent rates of return on invested capital — and the 300% return should becomes a modest target as well as reasonably commonplace occurrence. 

It’s  the kind of return some US PE firms were able to earn during the good years, but only by layering in a lot of bank debt on top of smaller amounts of equity. That model may still work, at some future time when banks again start lending at modest interest rates on deals like this. But, there’s an inherent instability in this highly-leveraged approach: cash flows are stretched to the limit to make debt payments. A bad quarter or two leads to missed repayments, and the whole elaborate structure crumbles: just think of Cerberus’s $7.5 billion purchase of 80% of Chrysler. 

China is in a world of its own, when it comes to PE investing. My best guess is that it remains the world’s best market for PE investment over the next ten years at least. Little wonder that many of the world’s under- or unemployed PE staff members are taking crash courses in Chinese. 

Here’s one of the slides from the PPT that accompanied a recent talk I gave  in Shanghai called “Trends in Global Private Equity: China as Number One”.

Private Equity in China  中国的私募股权投资: 

—Strong present, stronger future—  今天不差钱，明天更美好

—PE firms continue to raise money for investment in China, over $10 billion in committed   capital and growing —  私募股权基金仍在继续募集资金投资国内，规模已经为100亿美元并将继续增长

—Next 12 months : most active in history ; IPO window open; finding and financing China’s next national champions —  未来的一年：历史上最蓬勃发展的时期，IPO 重启，发现并投资中国下一批的企业明星

 

For whole presentation, please click: 私募股权投资：中国成为第一 

 


.

Shenzhen’s New Small-Cap Stock Market — A Faster Path to IPO. Not Always a Smarter Path

Leave a Comment / July 23, 2009

lichi painting from blog post by China First Capital

One of the main themes of the PE conference I attended last week in Shanghai was the launch of the Shenzhen Stock Exchange’s new Growth Enterprise Market “GEM”, for smaller-cap, mainly high-tech companies.

It’s been a long time in the planning – since at least 1999. In March 2008, China’s Prime Minister, Wen Jiabao, tried to kickstart the process and announced plans to open soon this second market in Shenzhen. Events then intruded – the credit crisis struck, financial markets tanked, and so plans for China’s GEM went into limbo.

Things are now back on track. Trading is likely to begin in October. At the conference, most of the speakers focused on hows and whys the GEM would open new opportunities for smaller companies to raise money from China’s capital market.

Overall, it’s a development I applaud. Private companies in China are often starved of growth capital, and the GEM will mean more of the country’s capital gets allocated to these businesses.

There is one aspect, however, of the GEM that I personally find a little less positive. It’s a small quibble, but my concern is that the opening of the GEM will lead still more Chinese companies to divert time and resources away from building their profits and market share and instead devote energy and cash towards going public. The smaller the company, the more potentially harmful this diversion of attention can be.

China is, to use a military analogy, a “target-rich environment”. Companies often have more opportunities than they have time or resources. This is the product of an economy growing very strongly (8% this year) and modernizing at lightning speed. Large companies can also suffer when they shift focus from gaining customers to gaining a public listing. But, they will usually operate in an established market with established customers. This gives them more of a cushion.

Smaller, high-tech companies don’t have as much leeway. For these companies (last year’s revenues under $5o million) the risk is that the time-consuming and expensive process of planning an IPO on GEM will severely impact current operations, causing it to miss chances to expand, and so lose out to better-focused competitors.

In other words, there’s a trade-off here that tends to get overlooked in all the excitement about the opening of this new stock market in China. The trade-off is between focusing on capital-raising and focusing on building your business.

In my experience, private Chinese companies are already often a little too fixated on an IPO. It’s the main reason so many have made the poor, and often fatal, choice to go public on the American OTCBB. The GEM, I fear, will add fuel to this fire. Often, the best choice for a fast-growing private Chinese company will be to ignore the many pitches they’ll hear from advisors to IPO, and hunker down by focusing on their business for the next year or two.

Yes, being a boot-strapped company is tough. There’s never enough cash around. I know this at first-hand, since along with running China First Capital, I’m also CEO of a boot-strapped security software company in California, Awareness Technologies. Our growth opportunities far exceed our ability to finance them. So, I can understand why the thought of raising an “easy” $5 million – $15 million by going public on the GEM is very attractive to any Chinese boss running a similar cash-short and opportunity-rich company.

But, capital always has a cost. In this case, the main costs will be both the cash paid to advisors and regulators, along with the indirect cost of being a beat slower to seize available opportunities to grow. In China at the moment, any slowness is not just a problem. It can be life-threatening. Every business here operates in a hyper-competitive marketplace.

Of course, any company that can raise money by going public on the GEM will eventually enjoy a big advantage over competitors. It will have the cash and the stronger balance sheet to finance growth. But, the IPO process in China remains far slower than in the US or Hong Kong. A company planning and funding its GEM IPO now, may need to wait two years or more to get all necessary approvals and so finally raise that money with an IPO. Meantime, competitors are, as Americans like to say, eating this company’s lunch.

It’s a discussion we often have with SME bosses – how to time optimally an IPO. A rule of thumb with IPOs is: “small is not beautiful.” Going public on the strength of still limited earnings and revenues will likely result in a small market cap. This can adversely affect share price performance, and so limit the company’s ability to raise additional equity capital. To avoid this trap, it’s often going to be better to wait. Let competitors get bogged down in IPO planning. You can then grow at their expense.

In one way, though, the establishment of the GEM market is an unqualified triumph. It sends the signal far and wide that private SME companies will play an ever larger role in fueling the growth of China’s economy.

 

 

.

In Global Private Equity, It’s China as #1

Leave a Comment / July 21, 2009

Qing ceremonial ruyi in China First Capital blog post

 

I spent the day in Shanghai on Friday, attending a private equity conference, and giving one of the keynote speeches. I’d thought about giving my talk in Chinese, but in the end, the discretion/valor calculus was too strong in favor of using my native language. I was one of only two speakers who used English — or in my case, a kind of half-bred version of miscegenated Mandarin and English. The rest of the conference participants — including two other Westerners and dozens who participated in panels – all spoke in Chinese.  It was quite humbling, and I’m determined to use only Chinese next time around. 

Shanghai has, so rapidly, become a truly international city. It’s one thing to say, as Shanghai’s leadership has been doing over the last decade, that Shanghai will surpass Hong Kong as Asia’s largest, most vibrant international financial center. It’s quite another to achieve this, or even make significant headway, as Shanghai has done. So many of the factors aren’t under the control of government authorities. They can only create the legal and tax framework. In the end, the process is driven by individual decisions made by thousands of people, who commit to learning English and mastering the basics of global finance. All are staking their careers, at this point, on Shanghai’s future as a financial center. 

It’s a version of what economists like to call “network effects”: the more individuals who commit to building Shanghai as a financial center, the more each benefits as the goal comes closer to fruition. On Friday, in Shanghai, I could see this process vividly displayed in front of me, of how widespread knowledge of English has become: of the 200 or so people who heard my talk, at a glance 99% were Chinese, and only a handful needed to use the translation machines.

My talk was titled “Trends in Private Equity: China as #1”.  In Chinese, it’s “私募股权投资：中国成为第一”

The basic theme was how “decoupled” China has become from private equity and venture capital investment in the rest of the world.  China is in the ascendant, and will remain that way, in my opinion, for the next ten years at least. It will be years before the PE and VC industries in the US reach again the size and significance they enjoyed a year ago. China, meanwhile, is firing on all cylinders.

There are many reasons for China’s superior current performance and future prospects. In my talk, I focused on just a few, including principally the rise over the last decade of a large number of outstanding private SME. They are now reaching the scale to raise successfully private equity and venture capital funding.

It’s another example of positive network effects: the Chinese economy is undergoing a shift of breathtaking significance: from dependence on the public sector to reliance on the private sector, or in my shorthand, “from SOE to SME”. The more successful SME there are, the more embedded this change becomes, and the more favorable overall circumstances become for newer SME to flourish. 

Here’s one of the slides from my PPT that accompanied the talk: 

—  Global Private Equity: in trouble everywhere except China
 全球私募股权投资：除了中国以外的其它市场都陷入困境

—  Recession; Credit Crisis; Over-leveraged ; closing IPO window

—  经济衰退，信贷危机，杠杆率过高，几近停止的IPO

—  Most PE firms dormant, can’t raise new equity or new debt; industry contracting

—  PE公司无法进行股权和债权融资，几乎处于休眠状态，行业萎缩

—  China is the exception:  strong economic fundamentals; shift from export to domestic market;  shift from state-owned to private sector;  rise of world-class SME

—  中国的独特之处：强劲的经济增长，从出口导向到关注国内市场的转变，经济从国有企业到私营企业的迁移， 富有成为世界级企业潜力的中小企业

 For anyone interested, the whole speech is available, in Chinese, at http://news2.eastmoney.com/090717,1117,1134998.html

 

 

.

 

Companies That Can IPO & Companies That Should: The Return to IPO Activity in China

Leave a Comment / July 8, 2009

Ming Dynasty lacquer in China First Capital blog post

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

.

China First Capital’s Report: 如何选择上市的时机和地点, “When and Where to IPO”

Leave a Comment / June 22, 2009

China First Capital Chinese-language Report on "Where and When to IPO" for Chinese SME

 

I’m flying back from China as I write this, and bringing with me something of great value to me personally — even if I can’t claim to recognize every character. It’s the Chinese-language report prepared by my China First Capital colleagues on how a Chinese SME can avoid the quicksand and plan a successful IPO. Built on a first draft in English of mine, it’s written specifically for Chinese SME bosses. The report is called “如何选择上市的时机和地点”. 

Download Here: 如何选择上市的时机和地点 “When & Where to IPO for Chinese SME”

We prepared the report with the explicit goal to help SME bosses make more informed decisions in capital-raising and IPO. There’s been an acute lack of reliable, well-researched information in Chinese on this topic. We hope the report will improve this “information deficit”. 

For me personally, this is the most important report we’ve prepared thus far for SME bosses. As this blog has discussed at length recently,  Chinese SMEs have been victimized disproportionately by every form of IPO indignity, from US OTCBB listings, to reverse mergers, Malaysian IPOs, SPACs and other schemes promoted by the predatory bankers, lawyers and advisors that swarm around China. 

Indeed, there are few bigger risks to a successful Chinese SME than making the wrong decision and heeding the wrong advice on where and when to IPO. 

I’d welcome feedback on the report. You can email me at ceo@chinafirstcapital.com

For those who can’t read the report in Chinese, it provides a comprehensive summary of pluses and minuses for Chinese SME of listing on the US, Hong Kong and Chinese stock markets. It also discusses at length, with several case studies,  the damage done to good Chinese SME by OTCBB listings and reverse mergers in the US. The bad examples abound. 

Even if you can’t read the Chinese, I hope you’ll consider sending it on to those active in China’s capital markets, as well as to any Chinese businessmen contemplating a public offering.  Better Chinese-language information is the strongest antiseptic to kill off the bad deals and bad dealmakers in China. So, I hope all those with a genuine interest in promoting entrepreneurship in China will help spread the word.



.

 

Size Matters – Why It’s Important to Build Profits Before an IPO

Leave a Comment / June 9, 2009

Qing Dynasty plate -- in blog post of China First Capital

Market capitalization plays a very important part in the success and stability of a Chinese SME’s shares after IPO. In general, the higher the market capitalization, the less volatility, the more liquidity. All are important if the shares are to perform well for investors after IPO.

There is no simple rule for all companies. But, broadly speaking, especially for a successful IPO in the US or Hong Kong, market capitalization at IPO should be at least $250 million. That will require profits, in the previous year, of around $15mn or more, based on the sort of multiples that usually prevail at IPO.

Companies with smaller market capitalizations at IPO often have a number of problems. Many of the larger institutional investors (like banks, insurance companies, asset management companies) are prohibited to buy shares in companies with smaller market capitalizations. This means there are fewer buyers for the shares, and in any market, whether it’s stock market or the market for apples, the more potential buyers you have, the higher the price will likely climb.

Another problem: many stock markets have minimum market capitalizations in order to stay listed on the exchange. So, for example, if a company IPOs on AMEX market in the US with $5mn in last year’s profits, it will probably qualify for AMEX’s minimum market capitalization of $75 million. But, if the shares begin to fall after IPO, the market capitalization will go below the minimum and AMEX will “de-list” the company, and shares will stop trading, or end up on the OTCBB or Pink Sheets. Once this happens, it can be very hard for a company’s share price to ever recover.

In general, the stock markets that accept companies with lower profits and lower market capitalizations, are either stock markets that specialize in small-cap companies (like Hong Kong’s GEM market, or the new second market in Shenzhen), or stock markets with lower liquidity, like OTCBB or London AIM.

Occasionally, there are companies that IPO with relatively low market capitalization of around RMB300,000,000 and then after IPO grow fast enough to qualify to move to a larger stock market, like NASDAQ or NYSE. But, this doesn’t happen often. Most low market capitalization companies stay low market capitalization companies forever.

Another consideration in choosing where to IPO is “lock up” rules. These are the regulations that determine how long company “insiders”, including the SME ownerand his family, must wait before they can sell their shares after IPO. Often, the lock up can be one year or more.

This can lead to a particularly damaging situation. At the IPO, many investment advisors sell their shares on the first day, because they are often not controlled by a lock up and aren’t concerned with the long-term, post-IPO success of the SME client.  They head for the exit at the first opportunity.

These sales send a bad signal to other investors: “if the company’s own investment advisors don’t want to own the shares, why should we?” The closer it gets to this time when the lock up ends, the further the share price falls. This is because other investors anticipate the insiders will sell their shares as soon as it becomes possible to do so.

There are examples of SME bosses who on day of IPO owned shares in their company worth on paper over $50 million, at the IPO price. But, by the time the lock up ends, a year later, those same shares are worth less than $5mn. If it’s a company with a lot market capitalization, there is probably very little liquidity. So, even when the SME bosshas the chance to sell, there are no buyers except for small quantities.

The smaller the market capitalization at IPO, the more risky the lock-in is for the SME boss. It’s one more reason why it’s so important to IPO at the right time. The higher an SME’s profits, the higher the price it gets for its shares at IPO. The more money it raises from the IPO, the easier it is to increase profits after IPO and keep the share price above the IPO level.   This way, even when the lock up ends, the SME boss can personally benefit when he sells his shares.

Of all the reasons to IPO, this one is often overlooked: the SME boss should earn enough from the sale of his shares to diversify his wealth. Usually, an SME boss has all his wealth tied up in his company. That’s not healthy for either the boss or his shareholders. Done right, the SME boss can sell a moderate portion of his shares after lock in, without impacting the share price, and so often for the first time, put a  decent chunk of change in his own bank account.

We give this aspect lot of thought in planning the right time and place for an SME’s IPO. We want our clients’ owners and managers to do well, and have some liquid wealth. Too often up to now, the entrepreneurs who build successful Chinese SMEs do not benefit financially to anything like the extent of the cabal of advisors who push them towards IPO. 

 

 

.

 

“The Great Unwind” — Jim Zukin’s Masterly Analysis of Global Financial Crisis & Opportunities for Chinese Companies to Benefit Through M&A

Leave a Comment / May 11, 2009

Ming Dynasty

Readers of this blog will know I’m a big fan of Jim Zukin, a founding partner of the investment bank Houlihan, Lokey, Howard and Zukin. We met again for lunch last week, in Los Angeles. 

I’ve had the pleasure of meeting, and befriending, quite a few smart, and highly successful businessmen and entrepreneurs. It’s probably been the most rewarding part of my career. But, even among such pretty stellar company, Jim Zukin stands out. I’m truly awestruck – which is not a quality I often exhibit — by his intellect, his charisma, his business savvy, his warmth and humor, his love for his family, his clear and incisive thinking on the largest issues of our time. 

Jim is also much, much better at investment banking than I will ever be. I tend to be somewhat stubborn and used to being in charge. But, Jim’s judgment as an investment banker is so much more thoroughgoing than my own, that he is one of the very few people I’ve known who, metaphorically,  I would follow unquestionably into battle. Like a good junior officer, I would,  “Salute, shut up, and do what I was told.” 

Jim shares with me a deep affection for China, and a great delight in doing business there. He spotted big potential opportunities for his firm in China several years ago, and personally traveled there frequently to get Houlihan Lokey’s office started and on a solid footing, which is where it is today. Jim is one of those people who seems to know more about more things than should be possible, let alone for a guy who’s also occupied with “minor” tasks like staying very close to his five kids and grandchild, while helping to run the thriving global investment bank he founded. 

Among the things Jim understands well (better than anyone I’ve run across) the remarkable moment in financial history we’re now living through – the US is struggling to rebuild its banking sector and recover from a serious credit crisis and recession, while China is awash in liquidity. Most experts look at this and see just one dimension – that China’s government will continue to use its massive foreign exchange reserves to buy US government debt, thereby providing some additional stability to US interest rates and the dollar. 

Jim Zukin sees beyond this – indeed well beyond the current horizon –  to another important aspect of the financial symbiosis between the US and China. Chinese companies, as Jim sees it,  now have the scale, the ambition, the growth potential and the financial resources, to acquire assets in the US. This could have transformational effects for the Chinese companies able to acquire businesses in the US, and no less of an impact on parts of the ailing US industrial base. China could, and should, become a buyer of quality Middle Market companies in the US. There are good reasons why: because these US assets will help the Chinese firm accelerate its growth,  improve distribution and customer base in the US, upgrade technology. One other reason: US Middle Market companies are comparatively cheap, at the current valuation multiples (often around 5x)  and dollar-renminbi exchange rate. 

Jim sees this opportunity earlier and more clearly than most of us. He does so, in part,  because he holds more substantive knowledge and insight about the US, China and the financial tsunami that has changed the world over the last year. He condensed some of this knowledge and insight into a Powerpoint called “The Great Unwind and Its Impact”. 

I recommend it as essential reading, for anyone who wants to understand better the current financial crisis and some longer-term impacts on China and the US.  There’s a large amount to chew on in Jim’s report, not just the section on China. It shows a breadth of understanding that help explain why Jim was able to build a perennially successful investment banking firm, as well as perhaps the only one that’s come through the current financial crisis stronger than ever. 

You can view it here:

http://www.scribd.com/doc/15194564/The-Great-Unwind-and-Its-Impact-By-Jim-Zukin

 

 

.