China venture capital

Valuations head down in Chinese Private Equity — but too low is as bad as too high

How much is an asset worth? When the asset is a Private Equity stake in a high-growth private Chinese company, it’s as much a question of timing and sentiment, as underlying value. 

It’s clear as 2008 ends that the steep falls in world stock markets this year are causing a general reappraisal of valuation multiples in PE deals in China. This is logical, and inevitable. 

It’s logical, because entry and exit multiples can’t be completely decoupled. When share markets fall, so do price-equity multiples for most public companies. Their unquoted peers should track downward also.

The element of inevitability is that in many instances, the multiples on some PE investments in China had reached unsustainably high levels. How high? That depends who you ask. To me, if the multiple exceeds ten times trailing earnings, for a company in anything but exceptional cases in the high-tech or healthcare sectors,  the price is too high. 

PE firms chased valuations up. Now, they are chasing them down.

As recently as this spring, there were still investments being made in China at multiples of 12 times or higher. It’s hard to imagine those same deals being done now at anything like that price. 

Usually, the high multiples were the outcome of a bidding war, where several PE firms were competing for the chance to invest in a Chinese company. I’m all in favor of this, that PE firms should compete for good opportunities. Like any competitive bidding process, it results in a fairer price to the seller. 

That’s a primary responsibility we have at China First Capital, to get our clients the highest valuation from the most suitable potential investor. Both are important: price and the firm doing the investing.                    

But, while a competitive market is a good thing, the high-altitude double-digit valuations are not. They create, at the very least, additional and unwanted pressure, post-investment, on companies to pursue growth at all costs. This is the only way a PE firm could hope to make a decent return. 

The more malign effect, in my view, is that they give false signals to the market: specifically, they can create valuation expectations among other laoban that are unrealistic and unattainable. This can then delay or even eliminate the possibility of these firms raising the PE funding they will need. That is in no one’s interest.

I met this past week with a couple of very smart, seasoned PE investors in Shanghai. All are expecting a more active period of investing ahead as the New Year begins, after several months of greatly reduced deal flow. They are also, of course, expecting lower valuations than were the case earlier this year.

As we all know, markets have a tendency to overshoot. I sense, perhaps, that the PEs are looking now for valuations that are as unrealistically low as they were unrealistically high just a few months back. 

This is a problem almost as severe as overly-high valuation expectations among companies. Low ball valuations (by which I mean low to mid- single digits) are only going to appeal to companies that have no other financing options, or who foresee problems ahead in their business – problems they will try to keep hidden from a potential PE investor. In other words, a company that would take money at three times last year’s earnings is probably one best left to its own devices. 

The future of PE in China — Big PE vs. Small PE

I never much liked the term “Private Equity” since it serves two very different meanings and even more different business models. That difference has never been more stark than it is today. There is what I like to call “Big PE” and “Small PE”. One is hurting, and the other is still thriving. Luckily for China First Capital, we focus working with the part of the PE industry that’s still in good shape.  

In Big PE, large-scale, multi-billion-dollar deals are done by famous firms of the likes of Kohlberg Kravis Roberts, Blackstone and Carlyle. In Small PE , another group of PE firms thrive by finding great companies, at an earlier stage in their development, and backing them with growth capital. 

Big PE targets larger, often publicly-traded companies, or divisions of these larger firms. Using a slug of equity to support a large pile of bank debt, these private equity deals are based on acquiring a controlling interest in a company, and can deliver outstanding results by tossing out tired and underperforming management teams, tightening up on operating efficiencies, investing for growth. In 1-3 years, if things go well, the Big PE firm exits the now-improved business through either a trade sale or primary stock market listing. 

What matters most here essentially is finding a poorly-run business, with a bad capital structure and often worse management. (To take one recent example among many, think of Cerberus’s purchase of Chrysler’s from Daimler.) Ideally, a Big PE firm can turn things around quickly after buying control, and get an exit where the debt is paid off, and the underlying equity gets a very high rates of return. 

There are two big problems now in Big PE: the drying up of credit, and the shrinking valuations put on the businesses spiffed up for sale by the PE firms.  The recession compounds the problems, since the deals are built on leverage, and the bank debt will often have aggressive covenants attached to it. Those covenants (generally targeting  operating metrics like increasing EBITDA) are much harder to achieve in a down economy. Covenants get breached, deals need to be restructured with the Big PE firm pouring in more of its own capital, and the time and value of an exit go in the wrong directions: it takes longer to make less. 

Not a good business to be in at the moment. 

Then there’s Small PE, which has never looked sounder. The core skill-set here never goes out of fashion. It’s the ability to find a great company with the potential to grow far larger. Small PE firms invest their own money, for a minority stake in a business. They then provide what help they can to management, and if they’ve chosen their portfolio investments well, will wait confidently for the optimal moment to achieve a very solid return on each individual investment.  

In other words, Small PE is not built on complex financial engineering, but on good, old-fashioned “stock-picking”. 

Last month, David Rubenstein, the co-founder and managing director of Carlyle Group, one of the biggest of the Big PE,  gave a presentation in Tokyo titled “What Happened? What Will Happen? A Look At The Changing Investment And Private Equity Worlds” . Rubenstein, who has made over a billion dollars personally in the PE industry, tried to summarize all the tectonic forces destabilizing Big PE. There’s a lot of alarming stuff in his presentation. The key line: “The Credit Crisis Has Dislocated the Private Equity Industry “. (If anyone would like a copy of the Rubenstein presentation, email me at peter@chinafirstcapital.com)                                                                                                                                          

Rubenstein’s prediction, which I share: Deals: Smaller, Less Frequent, More Overseas”. In particular, Rubenstein foresees more PE firms raising money to invest in Asia. The fact he cites: Asia private equity fundraising has increased but remains small at 9.2% of the $331 billion raised by U.S. PE funds in 2007 considering that the combined GDP of the above countries is 93% of the GDP of the U.S. 

No question, Big PE will now try to act more like Small PE. The problem they’ll face is that they’re not well structured to find, assess and invest in smaller-sized deals. My guess is that the good PE firms already operating in Asia – the ones we work with regularly at China First Capital – will  be able move quicker and smarter than their new Big PE rivals. Here I means firms like China Renaissance Capital, (www.crcicapital.com) which has a great record of finding strong middle-market companies in China, investing wisely and at fair valuations, and then working alongside management to create the operating conditions for an ideal exit. 

Rubenstein’s talk included a table showing the 2008 year-to-date performance of a number of the most well-known Big PE.  All the following have lost money this year. What you see here is a cumulative loss of many tens of billions of dollars:

􀂃 Tosca Fund – 62%

􀂃 Templeton Emerging – 50%

􀂃 Kensington/Citadel  –37%

􀂃 Satellite Overseas  -30%

􀂃 Marathon Global Equity – 20%

􀂃 Canyon Value Realiz. –20%

􀂃 Goldman Sachs Investment Partners –16%

􀂃 Deephaven Global –15%

􀂃 Millenium Global HY –14%

􀂃 Cantillon Europe –13%

􀂃 Zweig-Dimenna Intl. –8%

􀂃 Harbinger Offshore -5%

􀂃 Cerberus Intl. –3%

􀂃 Viking Global Equities –2%

The good Small PE firms are having far better years. My own prediction is that this performance gap will only widen over the next two years, as the deal pipelines for Asian PE firms we work with remain very strong. Big PE has to re-learn their approach, and try to master a new set of skills. All the while, they’ll be losing out on many of the best opportunities in Asia to their smaller, more nimble and more experienced rivals. 

It’s hard to find a dancing elephant. The reason: it’s hard to teach the elephant the steps. 

Home Is Where the Money Is: China Focuses on its Domestic Economy

It was President Richard Nixon who somewhat infamously remarked, “We’re all Keynesians now” in 1971, just about the time he launched a series of disastrous economic policies, including wage and price controls. This was right before Nixon’s fabled trip to China. 

Nixon is, of course, long gone, and a lot of Keynesianism theory has been discredited. But, China recently introduced its own brand of Keynesian-style economic stimulus package, totaling almost $600 billion. The purpose is to shore up the slowing Chinese economy, by increasing government spending by something like 15% of current annual gdp. That’s a very big chunk of change. 

Most of the money is meant to go towards infrastructure and poverty alleviation programs. It should help shield China’s economy from some of the ill effects likely to come from a recession in the US and Europe  – which for China, will mean slowing growth, if not an actual decline,  in exports and direct investment. 

The $600 billion stimulus package is an important sign of a larger change now underway in China’s economy. The huge domestic market, rather than exports, will be the main engine of growth from here on. This, in turn, bolsters the most compelling investment case for private equity investors in China.

The best investment opportunities will be those companies that have the products, services and potential to dominate in China’s domestic market. How to find these companies? The ideal businesses are those that already established themselves as high-quality producers for export markets, and are now turning their primary focus to the home market.  These companies already built manufacturing expertise and scale through exports. Ideally, they also continued to upgrade their OEM production to serve good global brands with higher-priced products, rather than as simply a low-cost, low-value producer.

An interesting comparison: this is the opposite of the strategy many of the best Japanese companies followed: they first achieved dominance in the very-competitive Japanese domestic market, then, battle-hardened, set out to conquer the world. Great examples of this are Toyota, Honda, Sony, Matsushita, Takeda Chemicals, Canon, Kao.

The Chinese approach is different, but no less powerful. Good Chinese companies have already mastered, through their OEM business, short product cycles and the importance of anticipating changing consumer taste.  Both are central to success in China’s domestic market as well.

At China First Capital, we’re fortunate to work with one client, Harson, that exhibits all the best characteristics of a Chinese business now building a dominant position in China’s domestic market. Harson began as an OEM manufacturer, and continually upgraded its manufacturing and product design to serve some of the best international brand names in its industry. Under its very able and far-sighted chairman, Harson then began, almost five years ago, to use that foundation to build its own domestic brand business in China.  That domestic business is now thriving, and moving forward, should account for over 60% of Harson’s projected $300mn in total revenues within two years.  

There will be no faster-growing large market in the world than China’s domestic market. The Chinese government will play a role, by spending on improving education and infrastructure. But, the great entrepreneurs, like Harson’s, will do even more to remake China over the next two decades and beyond by selling Chinese more of what they want and crave. 


Fraud in Private Equity Investing in China

A partnership at a successful Private Equity firm is one of the most rewarding, interesting, reputation-enhancing and lucrative jobs available anywhere. But, it’s not without its perils.

 

This was brought home rather dramatically recently. A partner I know at a China-based PE firm (one of the best, incidentally) recently found out that one of the companies he recently invested in may, in fact, be fraudulent. I didn’t ask for the details, and they weren’t volunteered. I offered my commiserations, and expressed my hope that everything would work out satisfactorily for him and his firm.  

 

This is not an isolated instance. Just recently, the four directors representing foreign investors’ interests in a Shenzhen-based credit company called Credit Orienwise Group, resigned from their directorships following the disappearance of its chairman, Zhang Kaiyong, in early September. Facts are still hard to come by, and may never become widely known. Credit Orienwise is a private company, and the investors are also under no obligation to disclose to the public just how much money has been lost in this fraud.  

 

On paper, Credit Orienwise looked to be a good company. It bills itself as one of the largest private credit guarantee companies and lenders to small and medium enterprises in Southern China.  

 

But, it now looks certain that some of the most experienced and well-managed PE investors in the world may have been defrauded.  

 

Credit Orienwise had received more than US$63 million from four of the largest and most experienced PE investors operating in Asia: the Asian Development Bank, GE Capital Equity Investments Ltd., Citigroup Venture Capital International and The Carlyle Group. It’s hard to find a business in China with a more gold-plated group of investors. Could it really be possible that all four failed in their DD to uncover any actionable evidence, or strong suspicions that would have steered them away from making the investment? And then, once having done so, where was the corporate governance?  

 

This looks to be a failure by investors of very dramatic proportions.  

 

Of course, investors – even the best – sometimes lose money. I recall someone once asking Warren Buffett for his worst investment decision. He smiled and said, “How much time do you have?”  

 

Markets change quickly.A management group can pursue a flawed strategy or fail to execute efficiently. All these “operational risks” are present, to some extent, in any investment. But, the risk of being defrauded is something else. It’s precisely the one risk that’s meant to be neutralized through effective DD and deal structure.  

 

It’s likely over 20 senior professionals – from PE firm partners to accountants and lawyers – were directly involved in the Credit Orienwise DD. Could all of them been swindled by Credit Orienwise’s Mr. Zhang? Perhaps. But, one thing is sure: those closely involved with this deal will never–should never — recover from this stain on their careers.  

 

Is investment fraud more widespread in China?  Circumstantial evidence might suggest so. It’s probably the biggest career threat to a PE and VC investor working in China. 

 

In my own experience as a VC, I’ve not had personal experience with an investment that turned out to involve fraud. I suspect this is true of most VCs and PEs. Fraud is rare, just because it is usually fairly easy to detect ahead of time – if not in the DD materials, than in the comments and character of the company’s leadership. 

 

 

Greed and prudence are the two core principles that guide the actions of a VC or PE investor. Which of these is the most important? As stories like this one involving Credit Orienwise suggest, it’s better for the PE or VC investor, especially in China, to let prudence be the final arbiter. 

Why Wall Street rules rule in China Private Equity Deals

Quite possibly, these have been the two toughest weeks in the history of Wall Street. Two of the largest, most well-established investment banks (Merrill and Lehman Brothers) have been shattered by losses in mortgage and derivatives markets. Two others, Goldman Sachs and Morgan Stanley, are now converting to traditional bank holding companies. Other banks are teetering, and the stock market itself has experienced some of its largest one-day losses ever. 

Amid all the change and turmoil, it’s worth remembering just what makes Wall Street so central to the world’s financial industry. The US capital markets are both the largest, and the most liquid in the world. This is no less true today than it was a month or a year ago. As important is the fact that Wall Street has developed, over the last 70 years, a set of rules, procedures and best practices for raising capital.   These have become the de facto global standard. Put another way: Wall Street rules rule. 

I’m reminded of this fact quite frequently these days. We’re in the process now, at China First Capital, of closing an investment round for one of our Chinese SME clients, from one of Asia’s most successful PE firms. The closing legal documents are weighty, running to over 300 pages in total. The governing law is Hong Kong’s. But, the actual text of many of the documents comes direct from US private equity and IPO closings, including numerous references to the “Securities Act of 1933”, the basic foundational law for share offerings done in the US since then. 

So, here we have a Chinese company obtaining equity capital from a Hong Kong-based investor, while the securities law cited is from the USA. It seems a puzzle at first, even allowing for the possibility our client may one day choose to list its shares in the USA. So, why the reliance on US law and practice? 

Quite simply, because it comes closest to striking an ideal balance between the often competing interests of management and outside shareholders. In economics terminology, this is known as the “principal-agent problem”. (For anyone who wants to read more, Wikipedia has a decent summary: http://en.wikipedia.org/wiki/Principal-agent_problem).  This describes the frequent, and often inevitable tensions that can arise between outside investors and the inside management that makes the day-to-day decisions. The management has access to far more information about a company than the providers of capital.   It’s important to keep these divergent interests aligned. That’s what a lot of US securities law assures. It does so by mandating, for example, how often board and shareholders’ meetings must be called, with what kind of notice period, and what rights an investor has to inspect the books and records of the company they’ve put money into. 

For private equity deals, the US has also evolved a series of specific protections for investors. These rules make sure, for example, that an investor has the right to sell its shares in a public offering, and to be kept fully informed during the IPO process. These are essential for the proper functioning of the global private equity industry. As you’d expect, the investor rights figure prominently in the closing documents for our client. I recognize the terms and conditions, since I’ve seen them, more or less verbatim, in PE and VC deals I’ve worked on in the US. 

So, while Wall Street may be undergoing the most far-reaching changes in several generations, it’s leadership position is unchallenged in resolving these principal-agent problems, and making the flow of capital more ample and more secure than it would be under any other legal structure. 

Moving From Transaction-Based to Relationship-Based in China’s PE Business

The PE industry in China is growing up. Fast. There are two key factors are at work. The first is the onrush of cash. The second is the onrush of talent.

 

Billions of new money is flowing into the Chinese PE industry. This is in marked contrast with the situation elsewhere. There’s not a lot of appetite for committing capital for any purpose except to invest in China. Other, traditional large PE markets (US and European buyout funds) are in cyclical decline, owing largely to the problems in global credit markets. Then, too, there’s the announced intention of the China’s $75 billion social security  fund to begin investing more freely in private equity firms in China.   

 

The weight of all this new money entering the China PE market is having an interesting effect on valuations. While valuations have certainly come down over the last year, they arguably would have fallen faster and farther if not for all the new money looking for opportunities. It’s what financial markets like to call “the weight of money” argument – the more cash there is around, the higher prices will rise. 

That’s one side effect of the new money entering the market. The other is that the level of professionalism, across the board, is rising in the PE industry. There’s a good reason for this. As the pool of capital grows, so too does the demand for higher levels of fiduciary responsibility and accountability. This is evident not just in tightening DD procedures, of course, but also in the involvement in the PE investment process in China of some the world’s leading professional service firms. 

This past week, I met with a Hong Kong-based partner at one of America’s largest and best law firms. This firm has been very active in China’s IPO market the last five years, and served as lead counsel for many of the larger public offerings by Chinese companies in US exchanges. This is a great business, with very fat fees. But, it’s also a highly cyclical one. The IPO market has cooled this year. So,  this firm has now made the shrewd decision to work on some smaller PE deals, rather than just the +$100mn IPOs they’ve relied on in the past.  The upfront transaction fees are, of course, lower. But, by getting involved earlier in a company’s financing process, at the time of PE financing, this law firm believes that it will be building a very solid base for the future. 

The calculation is very sound. By working on a PE financing today, the law firm will be ideally-positioned to serve as IPO counsel several years down the line. In other words, the firm is moving from being “transaction-based” to “relationship-based” , from targeting only high-dollar one-off IPO transactions, to building a longer-term relationship with a select number of very promising pre-IPO Chinese companies. Over time, this should yield far more revenue for the law firms that follow this path. There’s money to be made advising on PE investment rounds, on Board matters, on M&A work, and litigation. 

In principle, it’s an obvious shift to make, and more closely reflects best practices in the legal profession. In fact,  a good law firm, like a good merchant bank, should choose its clients wisely, and then commit to serving and advising them over the long-term. 

For us, at China First Capital, this is very much at the heart of our operating ethos. For larger law firms, it can sometimes be a tougher shift to make. For one thing, their existing fee structures make it harder to work with smaller clients.  The law firms will often need to cut fees as a way of building these longer-term relationships. That’s not always easy to do in a large law firm, where all partners are expected to generate maximum revenues. 

But, this change in mindset is happening. I know from experience, since this big US firm has offered to work with several of our clients, on their PE financings, and to cap their fees at an appropriate level. This is a great thing for our clients, since it gives them access to the best legal counsel possible, at a time when it will make a significant positive difference. The PE firms stand to benefit as well, since it should raise standards overall. 

This shift from transactional focus to relationship-building is more proof that China’s PE market is coming of age, and building the infrastructure on which to prosper for many decades to come. 

Infinite Opportunities ÷ Finite Capital

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery. 

Ideally Matched: Client and Investor

I’m just back in Shenzhen from a visit to a client in Kunshan, near Shanghai. For me personally, it was a particularly poignant trip. 

It’s the first time I’ve been back to Jiangsu since 1982, when I left Nanjing University. Thinking as much with my stomach as my head, I immediately on arriving at 9:30pm on Wednesday night cajoled Nina, my partner, to go on a late-night search of great Jiangsu food. I eventually lost count, but by the time I left, I must have had enough xiaolongbao to feed a nursery school.

 As thoroughly enjoyable as this “Jiangsu homecoming” was, it was not even close to being the highpoint of the trip. We spent two full-days with our client, in meetings with a very select number of Private Equity firms. The meetings, from my standpoint, were truly outstanding – a text-book example of how great businesses and a great institutional investors should interact.

In fact, our client and the PE investors were, to my eye, as well-matched as this pair of Tang Dynasty horses. 

As I told one of the PE partners afterward, I’ve been in a lot of initial meetings between companies and PE or VC firms. But, never was I involved in a investment meeting that was conducted at such a uniformly high level, with both company and investor executing at the highest level of accomplishment and professionalism. 

For the PEs, this was the second-round of meetings, following earlier ones in Shenzhen, with our client’s CFO, that focused primarily on the company’s financial performance. Our client’s core leadership and ownership, however, are both based in Kunshan. So, there was even more to discuss in this second round meeting. 

For our client, this was on-the-job training. They’ve built an enormously successful business, with sales this year in excess of $120 million, and a strong likelihood of becoming, within five years, a multi-billion dollar enterprise. But, the client has done all this without equity finance, using only retained earnings and bank debt. So,  they’d never before presented themselves to sophisticated and experienced equity investors.  They don’t come any more sophisticated and experienced that these particular PE investors, with track records, both as individuals and as firms, that put them at the top of their profession. 

Our client more than exceeded our highest expectations, preparing exhaustively and answering comprehensively. 

China First Capital works to find the right investor for its clients. Not the investor offering the highest valuation, or the quickest path to IPO. We give this a lot of thought, matching the strengths of our client to the strengths of a particular PE firm. Done right, it’s transformational for both company and investor: a case of the total value created not being just larger than the sum of the parts, but exponentially so. 

It’s early yet in the process. We’re planning on several more meetings with PE firms. But, I left Kunshan even more optimistic about our client’s future, building a great partnership with a PE investor. 

It may not sound like it, but it’s meant to be my highest compliment to both our client and the PE firms we met with this week:  the xiaolongbao were good. The meetings were better. 

The Ten Questions Every Laoban Should Answer Before Seeking PE Funding

One of the supreme satisfactions of my work – and I’m fortunate that my job offers quite a few – is the time spent advising laoban (“business owner” in Chinese) on the value of private equity investment. These owners are entrepreneurs, not financial engineers. So, the world of private equity deal-making and finance is often entirely unfamiliar. As I tell these laoban, in my less-than-fluent Chinese, “you have already done the hardest thing possible in business, by taking an idea, adding little or no capital, and created in China, the most competitive market in the world, a successful business of significant size and fantastic prospects.” Compared to this, anything will appear easy, including closing a round of equity capital from one of the leading private equity or venture capital firms. 

Now, of course, closing a PE investment round is anything but easy. It involves, at a minimum,  a sizable amount of time, stamina, senior-level attention, perseverance, transparency, thoroughness and commitment to building a fully-aligned partnership with an outside investor.  I’ve seen it from both sides, both as a CEO and as a venture capitalist. The process can seem like breaking rocks with a spoon. 

But, it’s always rewarding and inspiring for me to see how quickly our laoban start mastering the intricacies of raising capital. They climb the steep learning curve fast. But, it is still a learning curve, and I’ve often made the process harder by doing an inadequate job preparing them for their first meetings. In fact, there ought to be a typically wise four-character Chinese proverb, or chengyu, to describe it: “Good students. Poor instructor.” 

I’ll admit to being a poor instructor. But, an improvable one? I’d like to think so. 

Together with my colleagues at China First Capital, I’ve put together a list of ten questions laoban should expect to hear in a first meeting with a PE firm. The purpose: to give the laoban a quick sense of the scope and rigor of the PE investment process.   

Of course, in any first meeting with a professional PE firm, there will be many more than ten questions. It’s unlikely any PE would ask all – or even the majority – of the ten on the list. 

But, these owner-entrepreneurs are all outstanding problem-solvers. If they weren’t, they wouldn’t be running and owning the sort of businesses of interest to good PE investors. 

So, the questions are really just a catalyst, to get the laoban to think about how a sophisticated investor will evaluate his business. In other words, to see his business from the outside looking in. This is like refraction, where shifting the angle changes the quality of the light. 

Here are the ten questions.  There are no right answers, of course. Only a right mindset.      

 

  1.  How much of your equity are you selling?
  2. What will you use this equity investment for?
  3. When do you hope to complete this fund‐raising?
  4. When will you IPO?
  5. What are you looking for besides capital from an investor?
  6. How do you think you can double or triple your profits?
  7. How much is your valuation?
  8. Who are your competitors and what are your competitive edges?
  9. Can you please explain your strategy for growing faster than your competitors?
  10. Please give me brief summary of the jobs and the past experience of the most important members of your management team?

China and the USA – same bed, same dream

The world’s largest and soon-to-be second largest economies, the US and China, don’t seem at first glance to have very much in common. The USA is a new country with an old political system. It’s a little appreciated fact that the US political system, coupling a federal democracy with capitalism, is now arguably the world’s oldest, since it’s been going for 232 years without major changes. China, by contrast, is a very old country – indeed the oldest of all nation-states – but with very new, fast-evolving political and economic systems.

And yet, there are some powerful similarities, ones that appeal directly to me as a builder and financier of private companies. In terms of raw entrepreneurial talent and ambition, China and the US are all but identical. Now, granted, American and Chinese entrepreneurship can often take very different forms — the US is a mature economy that grows at a solid but hardly spectacular pace. Technology plays a key part in many of the best new entrepreneurial ideas. Think of Google or Facebook. China is booming, and every year, millions of move from subsistence farming to relative abundance, from have-nots to consumers.  Opportunities abound, in the most basic industries like agriculture and mining, all the way to biotech and semiconductors.

Even so, the entrepreneurial foundation of both China and the US is plainly, and remarkably, visible. A reverence for hard work, vigorous personal ambition, a keen eye for spotting opportunity, these are qualities shared by the people of both countries. It’s why I am so optimistic about the prospects of both countries. And also why I think that China and the US are the two best markets for private equity and venture investment. Entrepreneurship, more than capital, is what drives the process of private equity finance.

Dig still deeper, and you find other important commonalities. In both China and the US, the government does not, thankfully, cripple what my favorite economist, Gary Becker of University of Chicago, calls “the dynamic energies of the competitive private sector”. My hope and belief are that this will continue to be the case for many years to come, and that China and the US will continue to offer great opportunities for building great private companies like those we work with at China First Capital.

There’s always a conflict, in every large economy, between those who want to regulate and tax the private sector, and those who want to maximize the room for businesses to operate free of burdensome regulations and high taxation. Seen in the broadest terms, the US and China are together following one path, and Europe and Japan are following another. China and the US are still open to high-levels of commercial competition with limited government intrusion. This makes both countries more friendly toward the new ideas of entrepreneurs. Europe and Japan, by contrast, are more regulated, more taxed, more anti-competitive, and so less hospitable to the entrepreneurship that drives China and the US.

Entrepreneurs create wealth. Governments don’t. It’s a fundamental reality best understood and practiced in the US and China – and best understood, as well, by those whose capital is placed at risk in private equity deals. Capital goes to where the risk-adjusted returns are greatest. Today, that’s China and the US.

 It will be true tomorrow as well. 

DD Done Right

Due diligence is rarely anyone’s idea of fun and games. Nor should it be. And yet, several days into the process now I’m struck just how positive the process can be, when it’s done right, done well, done in an atmosphere of shared goals and shared respect. At its best, DD sets the tone for a long period of successful partnership and value-creation between a company and an investor. 

This week, DD kicked off between one of our China First Capital clients and the Private Equity firm intending to invest in the company’s first round of equity finance. The PE firm is among the best, and it operates with the precision of a Geneva watchmaker. The DD checklists sent in advance were exhaustive, prepared both in Chinese and English, encompassing legal, financial and managerial topics. 

Our client – after recovering from the initial shock on seeing the sheer volume of information to be collected and presented – dug in and worked until late each night over the weekend to get the material ready.  The laoban struck exactly the right note from the beginning, explaining to his sometimes-beleaguered staff, that the volume of DD material was conclusive proof that this PE firm would make a professional, highly-competent and valuable partner if the deal closes. 

In other words, it’s a step in a process of increased transparency, meticulousness and accuracy. This will benefit the company immediately, in its operations and planning, and ultimately put it in a far stronger position as it moves toward a successful public listing down the road.   

We insist to our clients that they embrace this approach:  “even as a private company, you should adopt the standards of a public one.” This makes the transition to a publicly-traded company, accountable to both to regulators and shareholders, infinitely smoother.  It’s also just good business. 

On Monday, the PE firm’s DD team arrived at our client’s office, and set right to work. The highest standards clearly pervade all aspects of the PE firm’s operation, from the team — led by a woman of uncommon intelligence, poise and grace —  to the lawyers and Big Four accountants chosen to assist. 

They set the right mood from the outset: one of professional collaboration and partnership, rather than of abrasive investigation. In two days of highly-focused scrutiny, with lawyers, accountants and the PE firm’s team working on parallel tracks, the investor got an enormous amount of its preliminary due diligence completed. On Day Three, they headed out to visit the client’s factory in a neighboring province. 

It’s an old truism of PE and VC investing that the one certainty of the DD process is that there will be surprises, generally of an unwelcome variety. The real question is how large are the surprises and how well they are addressed, by both PE firm and the target company. 

I have confidence that in this case, the DD process will continue in a spirit of shared purpose and reciprocal transparency. As a result, I foresee a great outcome for both our client and this PE investor. 

Are Chinese Private Equity valuations too low?

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

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

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.