China Private Equity

The CSRC Disciplines the IPO Process in China

Leave a Comment / June 11, 2012

By turns mysterious, unpredictable, overextended yet under-experienced, byzantine in its complexity and frustrating for all who deal with it, the CSRC (“证监会”) comes in for a lot of criticism. The Chinese stock market regulator makes and enforces the rules for all 3,200 public companies traded on the Shanghai and Shenzhen stock exchanges. Though modeled after the US Securities and Exchange Commission, the CSRC’s remit is far broader. It alone decides which companies will be allowed to IPO. It plays gatekeeper, not just referee.

To win CSRC approval, it is by no means enough, as it usually is in the US, to have an underwriter and a few years of audited financials. All of the seven hundred IPO aspirants waiting in the queue for CSRC approval have these. Only a small minority will manage to jump through all the CSRC hoops and win approval for an IPO. The CSRC makes its own judgment about a company’s business model, future prospects, management caliber, shareholder structure, customer concentration, competitive position, planned use of IPO proceeds, the cleanliness of any outside investor’s money, related-party transactions, the appropriate IPO valuation, even the marital status of a company’s founder.

In effect, the CSRC is doing its utmost to take the “caveat” out of “caveat emptor”, by detecting ahead of time any taint that could damage a company’s post-IPO process. The CSRC can of its own volition forbid companies in an industry to IPO, as it did recently with real estate developers and private steel companies.

The purpose is to starve them of capital. It can also, just as suddenly, reverse its prior course and allow once-blacklisted industries to access public markets. It seems to be doing this now with Chinese companies in the restaurant industry. It can also play favorites. Companies from China’s restive Xinjiang region are currently given special priority, and shown more leniency, in approving IPOs.

The CSRC’s approach to IPO screening is not dissimilar to the way Goldman Sachs chooses companies to underwrite. Each is trying to select “sure bets”, companies that won’t prove an embarrassment a few year’s down the road. Goldman does it to make money and keep its high reputation, the CSRC to avoid social upheaval. Keeping China’s stock markets scandal free is a matter of paramount national importance. So far, the CSRC has succeeded at this.

Accounting and disclosure scandals have become commonplace for Chinese companies quoted in Hong Kong and the US. Not in China. Credit the CSRC’s thorough IPO filtering. The CSRC also keeps a tight lid on the supply of IPOs each year to prevent new issues from weighing down overall market valuation.

There is another overlooked benefit to the CSRC’s stringent IPO approval process.  It weeds out the flim-flammery, hype and exaggerated salesmanship from the IPO process. Any company approved by the CSRC for an IPO is all but guaranteed a successful closing. The underwriters have it easy. They barely need to break a sweat.

The same is most definitely not the case in the US and Hong Kong, for example. There, regulatory approval is the first and simplest step in an expensive, tightly-choreographed, quite often unsuccessful effort by underwriters to drum up investor interest and get them to bite. It involves a fair bit of hucksterism.  In the US,  IPO underwriters are salespeople. In China, they are order-takers.

Chinese underwriters have limited discretion over IPO pricing. For one thing, the CSRC is watching, and can deal severely with underwriters who seek what the CSRC decides are “overpriced” valuations. It seems like everyone in China knows where IPO valuation multiples are at any given time. At the moment, they are around 35 times last year’s net income for smaller companies listing on the Chinext, and around 25 times for larger companies.  The CSRC has grown increasingly vocal in criticizing big first day gains for newly-IPO’d companies.

The CSRC does not approve IPO applications of companies that don’t have at least two years of profits or ones that have huge numbers of users, but comparatively light profits. That is to say, no Facebook, Groupon or Linkedin types are allowed. This, too, removes a lot of the investment banking sales wizardry seen in the US during the IPO process.

One positive result of this is that underwriters in China are limited in what they can promise companies to win an IPO mandate. Good, bad or indifferent, an underwriter is likely to get just about the same price for shares it sells in an IPO. So, basically, winning mandates in China comes down to a lot of wining and dining, Karaoke and cartons of expensive cigarettes.

Since the CSRC’s approval process can drag on for up to two to three years, underwriters also have little, to no, say over IPO timing. The risk in the IPO process in China is, overwhelmingly, the risk of rejection by the CSRC. The CSRC rules mean underwriters and company are in it together. The underwriter needs to be active throughout the long process, and present at many meetings with the CSRC. The underwriters put their neck on the line by providing guarantees to the CSRC on the soundness of a company’s financials and pre-IPO disclosure.

Having seen the process from both angles, ten years ago as CEO of a US company during part of its IPO process, and now in China, working with clients seeking CSRC approval, my view is that the CSRC’s method has a lot to recommend itself. It puts far more focus on the company and less on its investment banker. An IPO in China is not so much a test of an underwriter’s marketing prowess and placement network, but more state-directed capital deployment to companies deemed by the CSRC to be most suitable and fit to receive a slice of  the public’s savings. Who the underwriter is and how they operate are basically afterthoughts.

This may offend against the market principles of a lot of financial professionals, that the only real IPO test a company should need to pass is if an investor will send a check to buy its shares. But, “safety first” seems a good principle for China at this stage. Private companies have only had access to China’s capital markets, in a substantial way, for two years, with the opening of the Chinext (创业板）board.

The stock market is now –and will remain — the lowest-cost way to finance the growth of private enterprise in China. Everyone stands to lose if confidence is badly shaken, or a scandal takes down one of these once-private now-public companies. For this reason, though many investment professionals are mystified by its decisions and sudden about-faces, the CSRC earns my support and respect.

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Renminbi Funds: Can They Rewrite the Rules of Profitable Investing?

Leave a Comment / May 23, 2012

Renminbi private equity funds are the world’s fastest-growing major pool of discretionary investment funds, with over $20 billion raised in 2011. These Renminbi funds also play an increasingly vital role in allocating capital to China’s best entrepreneurial companies. Despite their size and importance, these Renminbi funds often have a structural defect that may limit their future success.

Most Renminbi funds are managed by people whose pay is only loosely linked, if at all, to their performance. They are structured, typically, much like a Chinese state-owned enterprise (“SOE”),  with multiple managerial levels, slow and diffuse decision-making, rigid hierarchies and little individual responsibility or accountability. The resemblance to SOEs is not accidental. Renminbi funds raise a lot of their money from state-owned companies, and many fund managers come from SOE background.

Maximizing profits is generally not the prime goal of SOEs. They provide employment, steer resources to industries favored by government plans and policies. A similar mindset informs the way many Renminbi funds operate. Individual greed along with individual initiative are discouraged. There are no big pay-outs to partners. In fact, in most cases, there are no partners whatsoever.

This represents a significant departure from the ownership structure of private equity and venture capital firms elsewhere. Partnership matters because it efficiently harnesses the greed of the people doing the investing.  The General Partners (“GPs”) usually put a significant percentage of their own money into deals alongside that of the Limited Partners who capital they invest. GPs are also highly incentivized to earn profits for these LPs. The usual split is 1:4, meaning the GP keeps 20% of net profits earned investing LPs’ money.

Of course, partnership structure doesn’t guarantee GPs are going to do smart things with LPs’ money. There’s lot of examples to the contrary. But, the partnership structure does seem to work better for both sides than any other form of business combination. GPs and LPs both know that the more the GP makes for himself, the more he makes for investors.

Renminbi funds, in most all cases, are structured like ordinary companies, or as subsidiaries of larger state-owned financial holding companies. Instead of partners, they have large management teams with layer upon cumbersome layer. The top people at Renminbi funds are picked as much for their political connections, and ability to source investment capital from government bureaus and SOEs, as their investing acumen. They are wage slaves, albeit well-paid ones by Chinese standards. But, their compensation might not even be 5% of what a partner at a dollar-based private equity firm can earn in a good year. A Renminbi fund manager will rarely have his own capital locked up alongside investors, and even more rarely be awarded that handsome share of net profits.

Renminbi funds differ in other key ways from PE and VC partnerships. The Renminbi funds usually have relatively flat pay scales, modest bonuses and a consensus approach with often as many as 20 or more staff members deciding on which deals to do.  A typical dollar-based PE fund in China might have a total of 15 people, including secretaries. A Renminbi fund? Teams of over 100 are not all that uncommon. The investment committee of a dollar PE firm might have as few as five people. Partners decide which deals to do. A Renminbi firm often have ICs with dozens of members, and even then, their decisions are often not final. Often Renminbi funds need to get investors’ approval for each individual deal they seek to do. They don’t have discretionary power, as PE partnerships do, over their investors’ money.

Renminbi funds have abundant manpower to scout for deals across all of China, and can throw a lot of people into the deal-screening and due diligence process. This bulk approach has its advantages. It can sometimes take a few months of on-the-spot paper-pushing, coaching and reorganizing to get a Chinese private company into compliance with the legal and accounting rules required for outside investment. Dollar funds don’t have that capacity, in most cases.

Also, Renminbi fund managers often have similar backgrounds to the middle management teams at private companies. They are comfortable with all the dining, wining, smoking and karaoke-ing that play such a core part of Chinese business life. The dollar funds? From partners on down, they are staffed by Chinese with elite educations, often including stints in the US working or studying.  Usually they don’t drink or smoke, and prefer to get back to the hotel early at night to churn through the target company’s profit forecast.

Kill-joys though they may be, the PE dollar funds still have, in my experience, some large – and most likely decisive — advantages over the Renminbi funds. Decision-making is nimble, transparent and centralized in the hands of the firm’s few partners. If they like a deal, they can issue a term sheet the same day. At a Renminbi fund, it can take months of internal meetings, report-writing and committee assessments before any kind of term sheet is prepared. Internal back-stabbing, politicking and turf battles are also common.

We’ve also seen deals where the Renminbi fund’s staff demand kickbacks from companies in return for persuading their firms to invest. An executive at one of China’s largest, oldest Renminbi fund estimates 60% of all deals his firm does probably include such under-the-table payoffs.

It’s often futile to try to figure out who really calls the shots at a Renminbi fund. Private company bosses, including several of our clients, are often loath to work with organizations structured in this way. The boss at one of our clients recently chose to take money from two dollar PE firms because he couldn’t get a meeting with the boss of the well-known Renminbi fund that was courting him hard. That firm compounded things by explaining the fund’s boss was anyway not really involved in investment decision-making and would certainly not join our client’s board.

The message this sent: “nobody is really in charge, so if we invest, you are on your own”. For a lot of China’s self-made entrepreneurs, this isn’t the sort of message they want to hear from an investor. They like dealing with partners who have decision-making power, their own money at stake alongside the entrepreneurs. PE partners almost always take a personal role in an investment by joining the board. In short, the PE partner acts like a shareholder because he is one, directly and indirectly.

At a Renminbi fund, the managers do not have skin in the game, nor a clear financial reward from making a successful investment. A Renminbi fund manager can be fired or marginalized by his bosses at any time during the long period (generally at least 3-5 years) from investment to exit. Private equity investing has long time horizon, and the partnership structure is probably the best way to keep everyone (GP, LP, entrepreneur) engaged, aligned and committed to the long-term success of a company.

It is possible for Renminbi funds to organize themselves as partnerships. But, few have done so, and it’s unlikely many will. The GP/LP structure is supremely hard to implement in China. Those with the money generally don’t accept the principle of giving managers discretionary power to invest, and also don’t like the idea of those managers making a significant sum from deals they do.

All signs are that Renminbi funds will continue to grow strongly in number and capital raised. This is, overall, highly positive for entrepreneurship in China. Hundreds of billions of Renminbi equity capital is now available to private companies. As recently as three years ago, there was hardly any. Less clear, however, is how efficiently that money will be invested. I know from experience that Renminbi funds find and invest in great companies. But, they also are prone to a range of inefficiencies, from bureaucratic decision-making to a lack of real accountability among those investing the money,  that can adversely impact their overall performance.

One way or the other, Renminbi funds will rewrite the rules for private equity investing, and eventually provide a huge amount of data on how well these managers can do compared to PE partners. My supposition is that Renminbi firms will not achieve as high a return as dollar-based PE firms investing in China. The reason is simple: investing absent of greed is often investing absent of profit.

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Private Equity in China, 2012: CFC’s New Research Report

Leave a Comment / April 26, 2012

Around the time of Confucius 2,500 years ago, the Greek philosopher Heraclitus wrote, “Nothing is permanent except change.” It’s a perfect quick summary of the private equity industry in China. In its short 20 year history, PE in China has undergone continuous transformation: from dollars to Renminbi; from a focus on technology companies to a preference for traditional industries; from overseas IPO exits to domestic listings;  from a minor financing channel to a main artery of capital to profitable private companies competing in the most dynamic and fast-growing major market in the world.

Where is private equity in China headed? Can future performance match the phenomenal returns of recent years? Where in China are great entrepreneurial opportunities and companies emerging? These are some of the questions we’ve sought to answer in China First Capital’s latest English-language research report, titled “Private Equity in China, Positive Trends and Growing Challenges”.

You can download a copy by clicking:  Download “Private Equity in China, 2012 – 2013“.

Our view is that 2012 will be a year of increasingly fast realignment in the PE industry. With the US capital markets effectively closed to most Chinese companies, and Hong Kong Stock Exchange ever less welcoming and attractive, the primary exit paths for China PE deals are domestic IPO and M&A. Both routes are challenging. At the same time, there are too many dollar-based investors chasing too few quality larger deals in China.

“Adapt or die” describes both the Darwinian process of natural selection as well as the most effective business strategy for PE investing in China.

I’ve been working with entrepreneurs for most of my 30 year business career. It’s the joy and purpose of my life. Good entrepreneurs profit from change and uncertainty. Investors less so, if at all. This may be the biggest misalignment of all in Chinese PE. The entrepreneurial mindset is comfortable with constant change, with the destruction and opportunity created by market innovation. In my view, the PE firms most likely to succeed in China are those led by professionals with this same entrepreneurial mindset.

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Chinese Private Equity Moves from IPO to IRR

1 Comment / April 10, 2012

Most investors, including me,  would be delighted to make 15% to 20% per year, year after year. But, for many private equity firms active in China, that kind of return would be cause for shame. The reason is that recent past returns from Chinese PE , and so the expectations of LPs, is much higher, often overall annual increases of 40%-60% a year, with successful individual deals increasing by 100% a year in value during a typical three to five year holding period.

But, it is quickly becoming much more challenging to earn those +40% annual rates of return. My prediction is that profits from PE investing in China will soon begin a rather steep downward slide. This isn’t because there are fewer good Chinese companies to invest, or that valuations are rising sharply. Neither is true. It’s simply that a declining percentage of PE deals done in China will achieve those exceptionally high profits of 500%-800% or more over the life of an investment.

The reason is that fewer and fewer PE deals in China will achieve exit through IPO. Those are the deals where the big money is made. There are no precise numbers. But, my estimate would be that in recent years, one in four PE investments made by the top 50 firms active in China managed to have an IPO. Those are the deals with the outsized rates of return that do so much to lift a PE firm’s overall IRR.

In the future, the rate of successful IPO exit may fall by 30% or more for the good firms. For lesser PE firms, including many of the hundreds of Renminbi firms set up over the last three years, the percentage of deals achieving a domestic IPO in China may not reach 10%. If so, overall returns for each PE firm, as well as the industry as a whole, will fall rather dramatically from the high levels of recent years.

The returns for most PE and VC firms across the world tend toward bell curve distribution, with a small number of highly successful deals more than covering losses at the deals gone sour, and the majority of deals achieving modest increases or declines. In China, however, the successful deals have tended to be both more numerous and more profitable.  This has provided most of the propulsive thrust for the high rates of return.

The higher the rate of return, the easier it is to raise new money. PE firms each year keep 1% to 2% of the money they raise every year as a management fee. It’s a kind of tithe paid by LPs. PE firms also usually keep 20% of the net investment profits. But, this management fee is risk-free, and usually is enough to fully pay for the PE and VC firms salaries, offices, travel and other operating expenses, with anything left over split among the partners.

So, high rates of investment return in the past ends up translating into lots of new money unlinked to actual investment performance in the future. It’s a neat trick, and explains why the PE partners currently most actively out raising capital are mainly those investing in China. The more you raise now, the longer your guaranteed years of the good life. In other words, even if overall investment results deteriorate in coming years, the guaranteed income of PE firms will remain strong. Most funds have a planned lifespan of seven to ten years. So, if you raise $1 billion in 2012, you will have perhaps $20mn a year in guaranteed management fee income all the way through 2022.

The more new capital that’s raised for PE deals in China, the more investment deals can get done. The problem is, IPOs in China are basically a fixed commodity, with about 250 private companies going public a year. These domestic Chinese IPOs are the common thread linking most of the highest return PE deals. The Chinese IPOs will continue, and most likely continue to provide some of the highest profits available to PE firms anywhere. But, with the number of IPOs static and overall PE investment surging, the odds of a PE-backed company in China getting the green light for IPO will drop — rather precipitously if the current gusher of new money for PE deals in China persists.

Meantime, the number of Chinese companies going public outside China is dropping and will likely continue to. The US has all but barred the door to Chinese companies, following a spate of stories in 2011 about fraudulent accounting and false disclosure by Chinese companies quoted there. In Hong Kong, the only Chinese companies generating investor enthusiasm at IPO are ones with both significant size (profits of at least USD$25mn) and an offshore legal corporate structure. It used to be both simple and common for Chinese companies to set up holding companies outside China. The Chinese government has moved aggressively to shut down that practice, beginning in 2006. So, the number of private Chinese companies with the legal structure permitting a Hong Kong (or US, Singapore, Korean, Australian) IPO will continue to shrink.

Add it up and the return numbers for PE firms active in China begin to look much less rosy going forward than they have in the past. More deals will end in mandatory buybacks, rather than IPOs. This is the escape mechanism written into just about every PE investment contract. It allows the PE firm to sell their shares back to the company if an IPO doesn’t take place within a specified period of time, typically three to five years. The PE gets its original investment back, plus an annual rate of return (“IRR”), usually 10% to 20%.

This way PE firms can’t get stuck in an illiquid investment. The buybacks should become an increasingly common exit route for PE deals in China. But, they only work when the company can come up with the cash to buy the PE shares back. That will not always be certain, since pooling large sums of money to pay off an old investor is hardly the best use of corporate capital. Fighting it out in court will likely be a fraught process for both sides.

The direction of Chinese PE is moving from IPO to IRR.  As this process unfolds, and PE returns in China begin to trend downward, the PE investment process and valuations are likely to change, most likely for the worse. IRR deals seldom make anyone happy—not the PE firms, their LPs or the entrepreneur.

Chinese PE still offers some of the best risk-adjusted returns of any investment class. But, as often happens, the outsized returns of recent years attracts a glut of new money, leading to an eventual decline in overall profits. In investing, big success today often breeds mediocrity tomorrow.


CFC’s New Research Report on Capital Allocation and Private Equity Trends in China

Leave a Comment / February 28, 2012

 

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Capital allocation, not the amount of capital,  is the largest financial challenge confronting the private equity industry in China. Capital continues to flood into the PE sector in China. 2011 was a record year, with over $30billion in new capital raised by PE firms, including both funds investing in dollars and those investing in Renminbi. China’s private equity industry seems destined now to outstrip in size that of every other country, with exception of the US. Ten years ago, the industry hardly existed in China.

Yes, it is a time of plenty. Yet, plenty of problems remain. Many of the best private companies remain starved of capital, as China’s domestic banks continue to choke back on their lending. As a result, PE firms will play an increasingly vital role in providing growth capital to these companies. 

These are some of the key themes addressed in CFC’s latest research report, titled “2012-2013: 中国私募股权融资与市场趋势”. It can be downloaded from the CFC website or by clicking here.

The report is available in Chinese only.

Like many of CFC’s research reports, this latest one is intended primarily for reference by China’s entrepreneurs and company bosses. Private equity, particularly funds able to invest Renminbi into domestic companies,  is still a comparatively new phenomenon in China. Entrepreneurs remain, for the most part, unfamiliar with all but the basics of growth capital investment. The report assesses both costs and benefits of raising PE.

This calculus has some unique components in China. Private equity is often not just the only source for growth capital, it is also, in many cases, a pre-condition to gaining approval from the CSRC for a domestic IPO. It’s a somewhat odd concept for someone with a background only in US or European private equity. But, from an entrepreneur’s perspective, raising private equity in China is a kind of toll booth on the road to IPO. The entrepreneurs sells the PE firm a chunk of his company (usually 15%-20%) for a price significantly below comparable quoted companies’ valuation. The PE firm then manages the IPO approval process.

Most Chinese companies that apply for domestic IPO are turned down by the CSRC. Bringing in a PE firm can often greatly improve the odds of success. If a company is approved for domestic IPO, its valuation will likely be at least three to four times higher (on price/earnings basis) than the level at which the PE firm invested. Thus, both PE firm and entrepreneur stand to benefit.

The CSRC relies on PE firms’ pre-investment due diligence when assessing the quality and reliability of a company’s accounting and growth strategy. If a PE firm (particularly one of the leading firms, with significant experience and successful IPO exits in China) is willing to commit its own money, it provides that extra level of confidence the CSRC is looking for before it allows a Chinese company to take money from Chinese retail investors.

From a Chinese entrepreneur’s perspective, the stark reality is “No PE, No IPO”.

CFC’s Jessie Wu did most of the heavy lifting in preparing this latest report, which also digests some material previously published in columns I write for “21 Century Business Herald” (“21世纪经济报道) and “Forbes China”  (“福布斯中文”). The cover photo is a Ming Dynasty Xuande vase.

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Song Dynasty Deal-Sourcing

1 Comment / December 5, 2011

I get asked occasionally by private equity firm guys how CFC gets such stellar clients. At least in one case, the answer is carved fish, or more accurately my ability quickly to identify the two murky objects (similar to the ones above) carved into the bottom of a ceramic dish. It also helped that I could identify where the dish was made and when.

From that flowed a contract to represent as exclusive investment bankers China’s largest and most valuable private GPS equipment company in a USD$30mn fund-raising. It’s in every sense a dream client. They are the most technologically adept in the domestic industry, with a deep strategic partnership with Microsoft, along with highly-efficient and high-quality manufacturing base in South China, high growth and very strong prospects as GPS sales begin to boom in China.

Since we started our work about two months ago, several big-time PE firms have practically fallen over themselves to invest in the company. It looks likely to be one of the fastest, smoothest and most enjoyable deals I’ve worked on.

No fish, no deal. I’m convinced of this. If I hadn’t correctly identified the carved fish, as well as the fact the dish was made in a kiln in the town of Longquan in Zhejiang Province during the Song Dynasty, this company would not have become our client. The first time I met the company’s founder and owner, he got up in the middle of our meeting, left the room and came back a few minutes later with a fine looking pale wooden box. He untied the cord, opened the cover and allowed me to lift out the dish.

I’d never seen it before, but still it was about as familiar as the face of an old teacher. Double fish carved into a blue-tinted celadon dish. The dish’s heavy coated clear glaze reflected the office lights back into my eyes. The fish are as sketchily carved as the pair in the picture here (from a similar dish sold at Sothebys in New York earlier this year), more an expressionist rendering than a precisely incised sculpture.

It’s something of a wonder the fish can be discerned at all. The potter needed to carve fast, in wet slippery clay that was far from an ideal medium to sink a knife into. Next came all that transparent glaze and then the dish had to get quickly into a kiln rich in carbon gas. The amount of carbon, the thickness and composition of the glaze, the minerals dissolved in the clay – all or any of these could have contributed to the slightly blue-ish tint, a slight chromatic shift from the more familiar green celadons of the Song Dynasty.

All that I knew and shared with the company’s boss, along with remarking the dish was “真了不起”, or truly exceptional. It’s the finest celadon piece I’ve seen in China. Few remain. The best surviving examples of Song celadon are in museums and private collection outside China. I’m not lucky enough to own any. But, I’ve handled dozens of Song celadons over the years, at auction previews of Chinese ceramic sales at Sotheby’s and Christie’s in London and New York. The GPS company boss had bought this one from an esteemed collector and dealer in Japan.

The boss and I are kindred spirits.  He and I both adore and collect Chinese antiques. His collection is of a quality and breadth that I never imagined existed still in China. Most antiques of any quality or value in China sadly were destroyed or lost during the turbulent 20th century, particularly during the Cultural Revolution.

The GPS company boss began doing business in Japan ten years ago, and built his collection slowly by buying beautiful objects there, and bringing them home to China. Of course, the reason Chinese antiques ended up in Japan is also often sad to consider. They were often part of the plunder taken by Japanese soldiers during the fourteen brutal years from 1931 to 1945 when they invaded, occupied and ravaged parts of China.

Along with the celadon dish, the GPS boss has beautiful Liao, Song, Ming and Qing Dynasty porcelains, wood and stone carvings and a set of Song Dynasty paintings of Buddhist Luohan. In the last few months, I’ve spent about 20 hours at the GPS company’s headquarters. At least three-quarters of that time, including a visit this past week, was spent with the boss, in his private office, handling and admiring his antiques, and drinking fine green tea grown on a small personal plantation he owns on Huangshan.

I’ve barely talked business with him. When I tried this past week to discuss which PE firms have offered him money, he showed scant interest. If I have questions about the company, I talk to the CFO. Early on, the boss gifted me a pretty Chinese calligraphy scroll. I reciprocated with an old piece of British Wedgwood, decorated in an ersatz Chinese style.

Deal-sourcing is both the most crucial, as well as the most haphazard aspect of investment banking work. Each of CFC’s clients has come via a different route, a different process – some are introduced, others we go out and find or come to us by word-of-mouth.  Unlike other investment banking guys, I don’t play golf. I don’t belong to any clubs. I don’t advertise.

Chinese antiques, particularly Song ceramics,  are among the few strong interests I have outside of my work.  The same goes for the GPS company boss. His 800-year old dish and my appreciation of it forged a common language and purpose between us, pairing us like the two carved fish. The likely result: his high-tech manufacturing company will now get the capital to double in size and likely IPO within four years, while my company will earn a fee and build its expertise in China’s fast-growing automobile industry.  

 

Xinjiang Is Changing the Way China Uses and Profits From Energy

Leave a Comment / December 6, 2011

 

Two truisms about China should carry the disclaimer “except in Xinjiang”. China is a densely-populated country, except in Xinjiang. China is short on natural resources, except in Xinjiang. Representing over 15% of the China’s land mass, but with a population of just 30 million, or 0.2% of the total, Xinjiang stretches 1,000 miles across northwestern China, engulfing not only much of the Gobi Desert, but some of China’s most arable farmland as well. Mainly an arid plateau, Xinjiang is in places as green and fertile as Southern England.

Underneath much of that land, we are beginning to learn, lies some of the world’s largest and richest natural resource deposits, including huge quantities of minerals China is otherwise desperately short of, including high-calorie and clean-burning coal, copper, iron ore, petroleum.  How, when and at what cost China exploits Xinjiang’s natural resources will be among the deciding issues for China’s economy over the next thirty years. Already, some remarkable progress is being made, based on two past visits. I return to Xinjiang tomorrow for five days of client meetings.

Because of its vast size and small population, Xinjiang hasn’t yet had its mineral resources fully probed and mapped. But, every year, the size of its proven resource base expands. Knowing there’s wealth under the ground, and finding a cost-effective way to dig out the minerals and get them to market are, of course,  very different things. Until recently, Xinjiang’s transport infrastructure – roads and railways – was far from adequate to provide a cost-efficient route to market for all the mineral wealth.

That bottleneck is being tackled, with new expressways opening every year, and plans underway to expand dramatically the rail network. But, transport can’t alter the fact Xinjiang is still very remote from the populated core of China’s fast-growing industrial and consumer economy. Example:  it can still be cheaper to ship a ton of iron ore from Australia to Shanghai than from areas in Xinjiang.

Xinjiang’s key resource, and the one with the largest potential market, is high-grade clean-burning coal. Xinjiang is loaded with the stuff, with over 2 trillion tons of proven reserves. Let that figure sink in. It’s the equivalent of over 650 years of current coal consumption in coal-dependent China . The Chinese planners’ goal is for Xinjiang to supply about 25% of China’s coal demand within ten years.

Xinjiang’s coal is generally both cleaner (low sulphur content) and cheaper to mine than the coal China now mainly relies on, much of which comes from a belt of deep coal running through Inner Mongolia, Shanxi and Shandong Provinces. Large coal seams in Xinjiang can be surface mined. Production costs of under Rmb150 a ton are common. The current coal price in China is over four times higher for the dirtier, lower-energy stuff.

For all its advantages, Xinjiang coal is not going to become a primary source of energy in China. The Chinese government, rightly, understands that the cost, complexity and long distances involved make shipping vast quantities of Xinjiang coal to Eastern China unworkable. Moving coal east would monopolize Xinjiang’s rail and road network, causing serious distortions in the overall economy.

Instead, the Xinjiang government is doing something both smart and innovative. It is encouraging companies to use Xinjiang’s abundant coal as a feedstock to produce lower cost supplies of industrial products and chemicals now produced using petroleum. All kinds of things become cost-efficient to manufacture when you have access to large supplies of low-cost energy from coal. Shipping finished or intermediate goods is obviously a better use of Xinjiang’s limited transport infrastructure.

I’ve seen and met the bosses of several of these large coal-based private sector projects in Xinjiang. The scale and projected profitability of these projects is awesome. In one case, a private company is using a coal mine it developed to power its $500mn factory to produce the plastic PVC. The coal reserve was provided for free, in return for the company’s agreement to invest and build the large chemical factory next to it. The cost of producing PVC at this plant should be less than one-third that of PVC made using petroleum. China’s PVC market, as well as imports, are both staggeringly large. The new plant will not only lower the cost of PVC in China but reduce China’s demand for petroleum and its byproducts.

Another company, one of the largest private companies in China,  is using its Xinjiang coal reserve, again supplied for free in return for investment in new factories, to power a large chemical plant to produce glycerine and other chemical intermediates. This company is already a large producer of these chemicals at its factories in Shandong. There, they run on petroleum. In the new Xinjiang facility, coal will be used instead, lowering overall manufacturing costs by at least 20% – 30% based on an oil price of around $50. At current oil prices, the cost savings, and margins, become far richer.

The key, of course, is that the companies get the coal reserve for free, or close to it. True, they need to build the coal mine first, but generally, that isn’t a large expense, since it can all be surface-mined.  This means that the cost of energy in these very energy-intensive projects is much lower than it would be for plants using petroleum or, to be fair, any operator elsewhere who would need to purchase the coal reserve as well as build the capital-intensive downstream facilities.

The Xinjiang projects should lock-in a significant cost advantage over a significant period of time. As investments, they also should provide consistently high returns over the long-term. While the capital investment is large, I’m confident the projects are attractive on risk/return basis, and that in a few years time, these private sector “coal-for-petroleum” projects will begin to go public, and become large and successful public companies.

The Xinjiang government keeps close tabs on this process of providing free coal reserves for use as a feedstock.  Since in most cases, these projects are looking to enter large markets now dominated by petroleum and its byproducts, there is ample room for more such deals to be done in Xinjiang.

Deals are getting larger. This summer, China’s largest coal producer, Shenhua Group, announced it would invest Rmb 52 billion ($8 billion) on a coal-to-oil project in Xinjiang. The company plans to mine 70 million tons of coal a year and turn it into three million tons of fuel oil.

Remote and sparsely-populated as it now is, Xinjiang is going to play a decisive role in China’s industrial and energy future, just as the development of America’s West has helped drive economic growth for over 100 years, and created some of America’s largest fortunes.  My prediction:  China’s West will produce more coal and mineral billionaires over the next 100 years than America’s has over the past hundred.

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Investment Banking in China — What I’ve Learned & Unlearned

4 Comments / November 2, 2011

Anyone seeking to succeed in investment banking in China should live by one rule alone: it’s not who you know, but how well you know them. In China, more than any other country where I’ve worked, the professional is also the personal. Comradeship, if not friendship, is always a necessary precondition to doing business together. If you haven’t shared a meal – and more importantly, shared a few hundred laughs – you will never share a business deal. Competence, experience, education and reputation all matter, of course. But, they all play supporting roles.

The stereotypical hard-charging pompous Wall Street investment banker wouldn’t stand much of a chance here. A “Master of the Universe” would need to master a set of different, unfamiliar skills. Personal warmth, ready humor and a relaxed and somewhat deferential attitude will go a lot farther than spreadsheet modeling, an Ivy League MBA and financial dodges to increase earnings-per-share.

I’ve been around a fair bit in my +25 year business career, doing business is over 40 countries and managing companies in the US, Europe and Asia. Everywhere, it helps to be likeable, attentive, courteous. We all prefer working with people we like.  But, since moving to China and opening a business, I’ve learned things work differently here. Making money and making friends are interchangeable in China. You can’t do the first without doing the second.

Investment banking is so personal in China because most private Chinese companies, from the biggest on down, are effectively one-man-shows, with a boss whose authority and wisdom are seldom challenged. Usually, there is  no “management team” in the sense this term is applied in the US and Europe. A Chinese boss is the master of all he (or often she, as women entrepreneurs are common here) surveys.

A substantial percentage of my time is spent getting to know, and winning the friendship, of Chinese bosses. This alone makes me a lucky guy. Without fail, the bosses I meet are smart, gifted, able, hospitable, warm. We don’t select for these qualities. They are prerequisites for success as a private business in China.

Bosses are also usually guarded about meeting new people. It comes with the territory. Anyone with a successful business in China is going to be in very large demand from a very large “catchment pool”, including just about everyone in the extended circle of the boss’s friends, relatives, employees, suppliers, political contacts. Everyone is selling or seeking something. Precious few will succeed. Being a boss in China requires enormous stamina, to deal with all those making a claim on your time, and a gift for saying “No” in ways that don’t offend.

For investment bankers, successful deal generation in China will usually follow an elliptical path. The biggest mistake is to start pitching your company, or a transaction, the moment you meet a prospective client. You need first to win the boss’s trust and friendship, then you can discuss how to work together. In my working life in China, it’s axiomatic that in a first meeting with a company boss, one or the other of us will say, “我们先做朋友”,  or “let’s become friends be first”. It’s not some throwaway line. It’s an operating manual.

The Chinese use a specific word to define the engagement between an investment banker and client. It speaks volumes about the way new business is won here. It’s “合作” or cooperation. You don’t work for a Chinese company, you cooperate with it. There’s got to be a real personal bond in place, a tangible sense of shared purpose and shared destiny.

I could probably teach a class in the cross-cultural differences of investment banking in China and the US. I’ve not only been active in both places, I’ve been on both sides of the table. Before starting CFC, I was CEO of an American company that retained one of the most renowned investment banks in the US to handle an M&A deal for us. At that company, we had a deep senior management team, including two supremely capable founders. We dealt individually and collectively with the investment bank, which had a similarly-sized team assigned to the project.

The relationships were professional, cordial. But, the investment bankers never made any real effort to become my friend, nor did I want them to. Rarely, if ever, did discussions veer away from how to create the conditions to get the best price. The bankers were explicitly pursuing their fee, and we were pursuing our strategic goal.

The deal went pretty smoothly, following a tightly-scripted and typical M&A process. The investment bank’s materials and research were first-rate, and they had no difficulty getting directly to decision-makers at some of the largest software companies in the world. They performed with the intricate precision and harmony of the Julliard Quartet.

I can count the number of times I sat down with the bankers for a nice meal where business was not discussed. Or the number of times when the meeting room rang with peals of friendly laughter. Zero. Both would be unthinkable in China.

Here, a deal is more than just a deal. Price is not the only, or even the main objective. Instead, as an investment banker, you must knit souls together, their lives, fortunes, careers, goals and temperaments. There is no spreadsheet, no due diligence list, no B-school case study, no insider jargon to consult.

Be likeable and be righteous. But. above all, do not be transparently or subliminally motivated mainly by personal greed. A successful Chinese boss will smell that coming from miles away, and recoil. You’ll rarely get past “ 您好” , the polite form of “hello”.

 

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Chengdu — Great City, but Where Are the Great Food Companies?

Leave a Comment / October 4, 2011

Ge dish from China First Capital blog post

Among major cities in China, Chengdu takes the prize as most pleasant, livable,  comfortably affluent, relaxed and charming. I arrived back here today. I’m reminded immediately there’s much to like about Chengdu, and one thing to love: the food.

Chengdu is famed for its “小吃”, (“xiaochi”) literally “small eats”. To translate 小吃 as “snack”, as most dictionaries do, doesn’t even remotely begin to do it justice. A 小吃  is a often one-bowl wonder of intense, jarring flavors. They not only take the place of a full meal with rice, they make the Chinese staple seem almost superfluous, a waste of precious space in the stomach.

There are about a dozen小吃 that can stop me in mid-stride, any time of day. These include several varieties of cold noodles, including the bean jelly ones called 凉粉, literally “cold powder”，as well as dandan noodles served dazzlingly hot, in both senses of the word.

My favorite 小吃 , by a wide margin, is 抄手 , literally, “to fold one’s arms”. It’s an odd name, since the last thing I’d ever do when I see a bowl of抄手 in Chengdu is fold my arms. They are always thrust outward, in anticipation.  抄手 is a bowl of wontons steeped in a fire-engine red soupy sauce, optimally with enough Sichuan pepper corn to numb the tongue all the way down the gullet. This frees up the nose to do the real work of decoding all the subtle flavors.

Offiically, Chengdu has a per capital income of around $5,200, about half Shanghai’s. But, I’d prefer living and working in Chengdu any day. So would many Chinese I know. The economy is doing well, despite some geographic disadvantages. Chengdu is the most westerly of China’s large cities, and so isolated from the most developed regions of China. It’s over 1,000 miles to Shanghai, Beijing, and almost as far to Shenzhen.

Chengdu is doing well economically – though you don’t always have a sense this ranks as high on the list of civic priorities as drinking tea and playing mahjong. The electronics and telecom industries are both doing well. Quite a few companies have received PE investment.

The one industry, however, that is still relatively undeveloped is the food business. This is odd. By logic, Chengdu should be a center of China’s food processing and restaurant industry. Not only is it a great food town, situated in a very region valley producing some of China’s best fruits and vegetables, but it is also capital of Sichuan Province.

Sichuan food is almost certainly the most popular “non native” cuisine across China. Within a mile of where I live in Shenzhen, there are probably over 50 Sichuan restaurants. It’s the same in Beijing, Shanghai and most other major cities.

There’s an innate association in Chinese minds between Sichuan and good food. In this, Sichuan reminds me a lot like Italy. Italian food is prized across all of the Western world, and as a result, some of the Western world’s biggest and most successful food companies are based in Italy. Among the larger ones are Barilla, Bertolli, Buitoni, Parmalat, Ferrero. These, and thousands of smaller ones making wine, cheese, salami, all benefit from the widespread popularity of Italian food, and the high market value of associating a food brand with Italy.

Chengdu and Sichuan should be no different. It should be the capital of China’s food processing industry. But, as far as I can tell, there are as of yet no great food companies or food brands based there.  If you shop around in Chengdu, the food products being marketed as “authentic Sichuan food ” are mainly an assortment of beef jerky, along with sweet and savory biscuits made from beans and peanuts.

There’s nothing wrong with any of these products, but there isn’t a big brand national brand among them. The mass market is going unserved.

Let’s look at two of the biggest food product categories where Sichuan brands should predominate: chili sauce and instant noodles. Each of these product areas have sales of billions of dollars a year in China. Yet, the leading brands come from outside Sichuan. In the case of instant noodles, the leaders are mainly Taiwanese and Japanese.

In chili sauce, the biggest brands all seem to come from Guizhou province. This, particularly, should cause a collective loss of face across Sichuan. Their spicy food  “owns” the palettes of hundreds of millions of people and yet the main brands of chili sauce in supermarkets come from the poorer province to its south.

The companies selling bottled pre-made Sichuan sauces (for popular dishes like Gongbao Jiding, Mapo Toufu and Yuxing Rousi) mainly come from Taiwan, Shanghai, even Hong Kong. It’s as if the most popular brands of spaghetti sauce were made in Brazil. Chinese food companies all over are eating Sichuan’s lunch.

This situation is unnatural and, I’d hope, unsustainable. Sichuan companies should by rights eventually dominate the market for many food products in China, much as Italian food companies are among the largest in Europe.

Some lucky PE investors should someday make a lot of money backing Sichuan food companies. Me and my company would love to play our part in this. Ambitious food entrepreneurs in Chengdu, call us anytime — 0755 33222093. If ever there were a billion-dollar unfilled market opportunity in China, this would be it.

 

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China: The World’s Best Risk Adjusted Investment Opportunity

1 Comment / August 21, 2011

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Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

  1. China’s current stage of six-pronged development (Slide 2)  
  2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
  3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
  4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
  5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
  6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9) 

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

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Private Equity in China, CFC’s New Research Report

Leave a Comment / August 14, 2011

 

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The private equity industry in China continues on its remarkable trajectory: faster, bigger, stronger, richer. CFC’s latest research report has just been published, titled “Private Equity in China 2011-2012: Positive Trends & Growing Challenges”. You can download a copy by clicking here.

The report looks at some of the larger forces shaping the industry, including the swift rise of Renminbi PE funds, the surging importance of M&A, and the emergence of a privileged group of PE firms with inordinate access to capital and IPO markets. The report includes some material already published here.

It’s the first English-language research report CFC has done in two years. For Chinese readers, some similar information has run in the two columns I write, for China’s leading business newspaper, the 21st Century Herald (click here “21世纪经济报道”) as well as Forbes China (click here“福布斯中文”) 

Despite all the success and the new money that is pouring in as a consequence, Chinese private equity retains its attractive fundamentals: great entrepreneurs, with large and well-established companies, short of expansion capital and a knowledgeable partner to help steer towards an IPO. Investing in Chinese private companies remains the best large-scale risk-adjusted investment opportunity in the world, bar none.

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China’s Most Profitable Industry Becomes One of the Toughest

4 Comments / July 7, 2011

Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. For the better part of twenty years, there’s been no simpler way to amass a great fortune than developing property in China.

The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning, and then pocket returns of 500% or more before the building was even occupied.

Continuously rising property prices, often increasing by 10% or more per month,  provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, so limiting even more the amount of capital needed, and improving return-on-equity even more.

There was just about zero risk in deals like this. Then, the Chinese government began clamping down, starting gingerly about a year ago and then with added ferocity in recent months,  in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare, as the central government in Beijing is no longer turning a blind eye.

More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems,  the more likely a project is to hit problems.

And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.

Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many of other unrelated assets, as collateral.

A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.

Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly, earlier this year, to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.

Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.

The bigger question is: has the game changed permanently in Chinese real estate, or will things revert as soon as inflation is down to where the government wants it to be. The rising real estate prices of the last 20 years have not only helped the country’s real estate barons. They have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits, while keeping the middle class feeling flush and contented. I’ll write about that in a following blog post.

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Crawling Blindfold & Naked Through A Minefield

1 Comment / June 27, 2011

 

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.

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China PE Firms Do PF (Perfectly Foolhardy) “Delist-Relist” Deals

Leave a Comment / June 22, 2011

Hands down, it is the worst investment idea in the private equity industry today: to buy all shares of a Chinese company trading in the US stock market, take it private, and then try to re-list the company in China. Several such deals have already been hatched, including one by Bain Capital that’s now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun.

From what I can gather, quite a few other PE firms are now actively looking at similar transactions. While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally would any PE firm reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it’s the fact there are several hundred Chinese companies quoted in the US on the OTCBB or AMEX with stunningly low valuations, often just three to four times their earnings.  That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders,  move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn’t it? It’s anything but. Start with the fact that those low valuations in the US may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty:  that the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing which, among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An “undervalued asset” in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the US. There’s no fixed price. But, it’s not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and so legal costs, are fearsome. Worse, lots can – and often will – go wrong, in ways that no PE firm can predict or control. The most obvious one here is that the PE firm, along with the Chinese company, get targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the US. When the deal involves a cash-rich PE firm and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law-firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less, but targets you for other opportunistic lawsuits that keep the legal bills piling up.

The PE firm itself ends up spending more time in court in the US than investing in China. I doubt this is the preferred career path for the partners of these PE firms. Bain Capital may be able to scare off or fight off the tort lawyers. But, other PE firms, without Bain’s experience, capital and in-house lawyers in the US, will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of an SEC investigation，or maybe jail time. Will the PE firm really be able to control the Chinese company’s boss from tipping off friends, who then begin insider trading? The whole process of “bringing private” requires the PE firm to conspire together, in secret, with the boss of the US-quoted Chinese company to tender for shares later at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules, by talking up the deal before it’s publicly disclosed, there’s no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm’s partners, on the other hand, are not likely immune. Some will likely be US passport or Green Card holders. Or, as likely, they have raised money from US institutions. In either case, they will have a much harder time evading the long arm of US justice. Even if they do, the publicity will likely render them  “persona non grata” in the US, and so unable to raise additional funds there.

Such LP risk – that the PE firm will be so disgraced by the transaction with the US-quoted Chinese company that they’ll be unable in the future to raise funds in the US – is both large and uncontrollable. The potential returns for doing these “delist-relist” deals  aren’t anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this “exit”, the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But, that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval  of China’s CSRC. Even for strong companies, without the legacy of a failed US listing, have a low percentage chance of getting approval. No one knows the exact numbers, but it’s likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these “taken private” Chinese companies will be more than slight. If there’s no certain China IPO, then the whole economic rationale of these “take private” deals is very suspect.  The Chinese company will be then be delisted in the US, and un-listable in China. This will give new meaning to the term “financial purgatory”, privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that US investors disparaged? I doubt it. How about Hong Kong? It’s not likely their investors will be much more keen on this shopworn US merchandise. Plus, these days, most Chinese company looking for a Hong Kong IPO needs net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the US than comparables in China. True. For good reason. The China-quoted comps don’t have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the US, and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

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