China Private Equity

Are Chinese Private Equity valuations too low?

Leave a Comment / February 10, 2009

Not long ago, just to ask the question would invite ridicule. But now, after the almost-halving of Chinese share prices so far in 2008, it’s more than appropriate to ask, “Are Chinese company valuations too low?”

My answer? Yes, they are too low.

According to the MSCI index, the current average PE ratio of all quoted Chinese companies is 16X, equal to Japan’s, and lower than the 18X average for US-quoted companies. In other words, investors are willing to pay more, on average, for a company’s earnings stream in the US than in China. And yet, of course, profit growth in China is, on average much higher.

It’s not at all remarkable to find Chinese companies whose profits are growing by over 40% a year. In fact, among our clients at China First Capital, that’s the norm, rather than the exception. Some clients’ profits double year after year. Not very many, if any,  US companies can match that rate of growth, for the simple reason that the overall US economy is stagnant, while China’s continues to roar along at a +10% growth rate. Corporate profits form a part of the calculation of gdp growth, and it’s historically true that corporate profits just about everywhere grow faster than the underlying economy.

That’s what makes the current PE valuation for China something of a conundrum. PE ratios are an expression, after all, of collective sentiment on the future rate of corporate profit growth. Clearly, China’s is now, and will likely remain for quite some time, higher than not only the US’s, but the rest of the world’s.  

It’s not hard to find good reasons for this steep drop in Chinese valuations this year. Bad news has come not as single spies, but as entire regiments in 2008. Natural disasters (the worst winter weather in 50 years, and then the horrific earthquake in Sichuan), the steady appreciation of the renminbi effecting China’s export competitiveness, the slowdown of the US economy, the end of pump-priming government spending in the run-up to the Olympics, the global rise in oil prices, and a near-doubling in inflation to +7% all contributed to investors loss of confidence, and with it, a decline in China’s share values.

But, this look like a classic case of a market overcorrecting. The decline in share prices, and with it China’s average PE ratio, certainly seem excessive.  The fundamentals are still very solid for very many Chinese businesses. Corporate profits, though under pressure in China as elsewhere, can sustain themselves at very high rates of growth. China’s best companies are improving margins, improving efficiency, quality and productivity, and focusing on the fast-growing Chinese domestic market.  In other words, good companies in China do exactly what the good ones in the US do – get stronger and leaner when times get tougher.

It seems to me that valuations will rise again soon, maybe not to the dizzy heights of a year ago, but to a level reflecting this one fundamental truth – nowhere else on the planet will corporate profits on a whole grow as fast, for as long into the future, as they will in China. 

The Term Sheet Goes Global

Leave a Comment / February 10, 2009

Time zones, languages, continents and business models may change as you cross the Pacific, but the Private Equity Term Sheet remains the same.

This is my conclusion after seeing the first Term Sheets arrive for our China First Capital clients recently. This is a happy moment – not so much for ourselves, of course, but for the entrepreneurs and PE firms we are fortunate to work with. For me, seeing these first Term Sheets is cause for reflection and, I hope,  some insight, on the constant truths of the equity investment process. 

I’ve been involved in quite a few Term Sheets for US venture deals over the years. I was surprised to find the Term Sheets this week very familiar, even though the investor and the target company are both based in China. In every other respect except the Term Sheet, the circumstances couldn’t be more different than a typical US venture deal — the governing law,  the industry, the company’s ownership, the likely timing and nature of the exit. 

So, why, despite all these vast differences, are there such deep similarities in Term Sheets? Start with the fact that there’s commonality in the approach of all good institutional investors: they all must exercise fiduciary responsibility on behalf of those whose money they are investing. This, in turn,  means the due diligence process needs to be thorough and professional, and the terms under which investments are made be sufficiently protective of the source of the invested capital. 

This fiduciary duty is made concrete in many of the standard provisions of a Term Sheet, whether that Term Sheet originates in Palo Alto or Shanghai. Indeed, the majority of the text in a Term Sheet is there to protect the fund’s Limited Partners from bad outcomes: share structure (preferred), board seats, liquidation preferences, anti-dilution provisions, preemptive rights, matters requiring special approval, performance guarantees. 

So far so familiar. 

The other big element of any Term Sheet, of course, is where the PE or VC firm is asserting primarily its own interests. The two most obvious areas: expiration dates and “no shop clauses”.  I was mildly surprised to see these in the Term Sheets recently submitted to clients of China First Capital. I’d mistakenly thought the “no shop clause”, in particular,  expressed a very local, American legalistic reality. In business negotiations, Americans need to specify as much as possible in writing, to protect against the ultimate evil of American business life: business litigation. 

Chinese, though, seem to have a far less obsessive need to document everything in writing, and certainly don’t have the same persistent, gnawing fear of litigation. It’s a “guanxi” society, where trust between individuals forms a more insoluble bond than any contractual term. 

A part of me, therefore, wishes the “no shop” clause hadn’t crossed the Pacific. I view them as the Pre Nuptial Agreement of the PE and VC investing world. They can create an air of mutual distrust, at a time when both sides are trying very hard to build a lasting partnership. 

A Term Sheet should serve the same fundamental goal: to allow great PE investors to put capital to work in truly outstanding investment opportunities, while limiting risk for the owners of that capital. I’m excited that the Term Sheets I’ve reviewed this week, once finalized,  will achieve this goal, and achieve phenomenal outcomes for everyone involved. 

IPO Exit Window — as it slams shut for US companies, it opens ever wider for Chinese ones

Leave a Comment / February 10, 2009

That sound you just heard was the IPO window slamming shut for venture and PE-backed companies in the US. In the second quarter of this year, not a single US company went public. This is the first time this has happened since 1978, when the US VC and PE industry was 1% its current size. In other words, these are unusually tough times for the US venture and PE community.

 

Will China soon follow suit? Not likely, in my view. In private equity, as in so many other industries, China and the US are becoming more and more decoupled. Chinese companies will continue to go public, on the US market, as well domestically and in other Asian markets, including Hong Kong and Singapore.  I remain very optimistic about the prospects of Chinese companies now getting PE and venture finance – and no less optimistic about how well many of these investments will do for the PE firms that are investing. For Chinese companies, IPOs and other exits, including trade acquisition,  will continue, at exit values that will reward those investing at typical pre-IPO multiples in China of 6-9x last year’s earnings.

 

Why the different path for Chinese and US companies backed by PE and VC firms? Start with the economy. The US is going through a period of very slow growth, close to, but not yet in, a recession. This, plus the effect of high oil prices, have weighed heavily on the US stock market, which in turn, limits the appetite among investors for IPOs by US companies. IPOs are traditionally far more difficult to arrange during a time of falling stock prices.

 

China’s stock market – as well as those of Singapore and Hong Kong – have followed the US down. That correlation between stock markets still exists. But, even during a down market, Chinese companies can still succeed with a public offering. In Hong Kong, whose overall market has fallen by 18% so far this year, Chinese companies are still going public at a rate of about one a day.

 

What explains this? A big part of it, in my view, is that too much venture and equity capital in the US has gone into technology and biotech, and less to established and profitable businesses. Don’t get me wrong. The technology market in the US is great, and I’m still active in the US venture community. But,  this heavy concentration on two sectors, technology and biotech, is itself a cause of the IPO drought of 2008. Those two industries tend to be both hyper-competitive and volatile. For every Google that goes public, there are dozens of tech companies that take VC funding and then disappear without a trace. A huge percentage of the venture funding goes to early-stage businesses, with zero or limited revenues, and perhaps only some untested IP.

 

So, while American VCs bet heavily on two high-risk/high-reward industries, the overall stock market is made up of many different sectors, with different rates of growth, maturity and different capabilities to respond to competition. In fact, the vast majority of companies listed on the US exchanges aren’t in the technology or biotech industries.

 

Let’s look now at Chinese companies getting PE and VC funding and going public. They are drawn from a far wider range of industries than their US counterparts. The Chinese PE market doesn’t focus on technology companies, or biotechs, or indeed on any single industry. This is a great strength. Chinese companies getting equity finance and then an IPO exit reflect, far more broadly, the overall composition of the stock market, and so the overall investor demand.

 

The other key differentiator  – the Chinese economy continues to grow strongly. It’s increasingly powered by domestic consumption, and will be for decades to come. This, in itself, creates enormous opportunities for the creation of very valuable businesses serving the Chinese domestic market – example:  consumer goods and the businesses that supply those producers.  We are working with a client that manufactures a key component used in disposable diapers, a market that will likely grow by upwards of 50% a year. Fewer than 15% of China’s babies are being swaddled in disposable nappies, compared to over 90% in most middle income countries.

 

My conclusion – as long as private equity capital in China continues to flow into great companies in a wide variety of industries, particularly ones that service the domestic economy, the Exit Window will remain not only open, but ever-larger. 

A word of welcome

Leave a Comment / February 10, 2009

A very warm welcome to all readers of this blog. My goal is to communicate ideas and trends that will contribute to the success of China’s Private Equity industry.