Chinese SME

The Hidden Unicorn: China Venture Capital Fails to Spot OnePlus

Leave a Comment / June 3, 2015

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Missed investment opportunities are rarely this glaring. Despite having hundreds of firms managing billions of dollars and employing thousands of people all supposedly out scouring China for the next big thing, China’s venture capital industry not only failed to invest in the single-most successful startup in recent Chinese history, mobile phone manufacturer OnePlus, most failed even to take note of the company’s existence. Meantime, a fair chunk of the tech savvy population of Europe and the US was enduring long waits and by-invitation-only rationing system to buy one of its prized mobile phones.

Since its founding less than a year-and-a-half ago, OnePlus went from bootstrap startup to likely “unicorn” (a billion-dollar-plus valuation) faster than any company in Chinese history. Unlike China’s other unicorns — Xiaomi, Meituan, newly-merged Kuaidi and Didi Dache and drone maker DJI Innovations — OnePlus hasn’t yet raised a penny of VC or private equity money.

With its first phones going on sale just one year ago, OnePlus has racked up a rate of growth as well as a level of brand awareness in Europe and the US never seen before from a new Chinese electronics manufacturer. OnePlus is the real deal. Revenues last year from May through December were $300mn. This year, OnePlus is on track to surpass $1 billion in sales, mainly in the highly-competitive US and European mobile phone market.

Over roughly that same period, China PE and VC firms invested over $15 billion in 1,300 Chinese firms, many also operating in the mobile industry, either as manufacturers or service providers. Needless to say, not a single one of these VC-backed startups has performed as well over the last year as OnePlus, nor created half as much buzz.

If China venture capital has a big fat blind spot it’s for companies like OnePlus. That’s because China venture capital –  which now trails only the US in the number of firms and capital raised –  is most comfortable backing Chinese companies that copy a US online business model and then tweak it around the edges to make it more suitable to the China market.

OnePlus couldn’t be more dissimilar. It is disruptive, not imitative. It takes a special kind of venture investor to recognize and then throw money behind this kind of business. OnePlus’s bold idea was to compete globally, but especially in the US and European markets, against very large and very rich incumbents —Samsung, Google, LG, Motorola, HTC — by building a phone that targets their perceived weak spots. As OnePlus sees it, those competitors’ phones were too expensive, too slow, of middling quality and the Android software they run too difficult to customize. At the same time, OnePlus sought to turn the sales model in the US and Europe on its head: no retail, no carrier subsidy, phones built-to-order after the customer had paid. Until a month ago, only those with an invitation were allowed to buy.

Nothing quite like it had ever been attempted. Will OnePlus continue its ascent or eventually crash-and-burn along with other once high-flying mobile brands like Blackberry and Nokia? Whichever happens, it’s already achieved more with less than any Chinese company competing for market share in the US and Europe. That augurs well.

From my discussions with OnePlus’s 25 year-old co-founder Carl Pei, it seems few China-based venture firms sought out the company and those that did failed to make much of an impact. The company instead opted to run on a shoestring, by cutting the need for working capital by building phones only after the customer paid. They also economized on marketing and advertising, typically where much venture money gets burnt.

OnePlus spent a total of about USD$10,000 on advertising. Instead, it poured its effort and ingenuity into building a mass following on the three major US social media platforms, Youtube, Twitter and Facebook. There’s no better, cheaper or more difficult way now to establish a brand and build revenues than getting lots of praise on these social networks. OnePlus’s success at this dwarves anything previously achieved by other Chinese companies. Compared to Xiaomi, OnePlus has double the Facebook likes, four times the Twitter followers and five times more Youtube subscribers. All three, of course, remain blocked inside China itself.

Sales of OnePlus phones also got an immeasurable boost from a string of flattering reviews in some of the most influential newspapers and tech blogs in the US and Europe.

Having reached a likely billion-dollar-plus valuation and billion-dollar revenue run-rate as a very lean company, OnePlus is now near closing on its first round of venture finance. But, it is planning to raise money in Silicon Valley, not from a VC firm in China. DJI just opted for a similar strategy, raising $75 million from Accel Partners of Palo Alto at an $8 billion valuation to expand its sales and production of consumer and commercial drones. DJI, like OnePlus, is based in China’s high-tech hub, Shenzhen.

One can see a pattern here. Many of China’s more successful and globalized companies prefer to raise money outside China, either by listing shares abroad, as Alibaba did last year, or raising money direct from US venture firms. US-based venture firms were early investors in Baidu, New Oriental Education and Ctrip , all of which later went on to become multi-billion-dollar market cap companies listed in New York.

Why do so many of China’s best companies choose to raise money outside China, despite the fact there’s now so much money available here and valuations are often much higher in China than outside? I have my theories. One thing is indisputable: being local hasn’t conferred much if any advantage to China’s venture capital industry.

Being China’s hidden unicorn hasn’t evidently done OnePlus much harm. It has revealed, though, some blinkered vision at China’s venture capital firms.

 

China High-Yield Debt Investing — the new China First Capital Research Report Published Today

Leave a Comment / April 21, 2015

China High Yield Investing -- China First Capital research report

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China First Capital today publishes a special research report titled, “China Debt Investing: An Overlooked Opportunity”. You can download a copy by clicking here.

This report examines some of the unique attributes of China debt investing, especially its fast-growing high-yield “non bank” shadow banking sector. Do the high yields adequately price in risk? Is this an investment class international investors should consider? Can the regulatory Great Wall be scaled to get dollars legally in and out for lending in China?

Little has been written in English about China’s huge high-yield debt market except constant predictions of its imminent catastrophic demise. Search “China shadow banking crash” and Google turns up 390,000 books and articles in English, some dating back five years now. One sample among many, a 2013 book by James Gorrie titled, “The China Crisis: How China’s Economic Collapse Will Lead to a Global Depression”. It perfectly captures the near-unanimous tenor of Western experts and analysts that shadow banking is the iceberg China has already struck. Losses will run into the billions of dollars, we are told, and China’s entire banking industry will teeter and perhaps collapse in a devastating replay of the 2008 financial crisis in the US and Europe.

Those of us in China inhabiting the world of fact rather than prediction, however, will have noticed that there is no crisis, no iceberg, no titanic upsurge of defaults in China’s shadow banking systems. In fact, it is by far the world’s largest, and using actual default statistics rather than somebody’s forecast, the least risky high-yield debt market in the world. There’s good money to be made.

Our report offers only one prediction — that as rules are loosened, global institutional capital will begin to put money into high-yield lending in China, likely by making direct loans to the best of China’s corporate and municipal borrowers. They will do so because debt investing in China offers institutional investors diversification as well as potentially higher risk-adjusted returns than private equity or venture capital.

The report examines high-yield lending in China as an investment strategy for fixed-income investors.  In that, it may well be a first to do so. Are there risks in the high-yield market in China? Of course, as there is in all fixed-income investing, including, in theory, the safest and most liquid of all instruments, US Treasury bills, bonds and notes.

Are actual default rates in China high-yield lending likely to surge above the current reported level of 1%? Yes, it seems entirely possible. But, this hardly invalidates the attractions of lending there. Instead, it means lenders, be they large credit funds or institutional investors acting directly as a source of debt capital to borrowers in China, should perfect their collateral at the outset,  do first-rate credit analysis before money moves and then, no less important, be extremely hands-on with on-site cash flow monitoring after a loan has been made.

There are 1,000 good reasons for institutional investors to consider China’s high-yield debt market. That’s because of the 1,000-basis point yield premium available in China compared to making similar types of loans against similar collateral to similarly rated companies outside China. In other words, an investor can earn far more with an intelligent direct lending strategy than is possible in all other major economies, as well as more than one can earn even in poorer domains like Indonesia and India.

The report looks at lending and credit markets in China from several different vantage points, including a few case studies. It’s a fascinating topic for anyone who wishes to learn more. Why are interest rates so much higher in China? Who are the winners and losers? Why is it there this near-unanimous view among English-speaking financial analysts and media folk that the high-yield market in China is on the verge of a ruinous crash? Do they share a common gift for doom-laden exaggeration like Nostradamus or will before very long be proven right at last?

I know which way I vote on that, that the shadow banking industry will certainly suffer some stumbles, with individual deals going sour and money being lost. But, as more money enters China for the purpose of providing debt capital, the shadow banking industry will mature, will improve its credit-analysis and credit-pricing skills, and smart investors will do well both relative to other fixed-income investment strategies worldwide as well as compared to private equity investing in China.–

 

China’s loan shark economy — Nikkei Asian Review

Leave a Comment / June 25, 2016

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China loan sharking

China’s loan shark economy

PF

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What’s ailing China? Explanations aren’t hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.

Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China’s economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies, especially in the private sector where most of the best Chinese companies can be found, are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.

Logic would suggest that the high rates price in some of the world’s highest loan default rates. This is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany, all countries incidentally where companies can borrow money for 2-4% a year.

You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting that the banking system in China is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money overseas, including Hong Kong-listed property developer Kaisa Group, have come near default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.

Combine sky-high real interest rates with near-zero defaults and what you get in China is now probably the single most profitable place on a risk-adjusted basis to lend money in the world. Also one of the most exclusive: the lending and the sometimes obscene profits earned from it all pretty much stay on the mainland. Foreign investors are effectively shut out.

The big-time pools of investment capital — American university endowments, insurance companies, and pension and sovereign wealth funds — must salivate at the interest rates being paid in China by credit-worthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. They are kept out of China’s lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.

This is starting to change. But it takes clever structuring to get around a thicket of regulations originally put in place to protect the interests of China’s state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms while giving lenders outside China access to the high yields best found there.

China’s high-yield debt market is enormous. The country’s big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.

Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the so-called shadow-banking sector, are now in excess of 100 trillion yuan ($15.9 trillion) or about double total outstanding commercial loans in the U.S. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability and distorting investment and rational long-term planning.

A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding recently has done. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don’t all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.

Chinese loans are not only expensive, they are just about all short-term in duration — one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won’t lend for longer.

The loans get called every year, meaning borrowers really only have the use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world’s most overpriced and rigid credit systems.

It is now taking longer and longer to renew the one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal money-lenders to tide them over after repaying last year’s loan while waiting for this year’s to be dispersed. The cost for this so-called “bridge lending” in China? Anywhere from 3% a month and up.

Again, we’re talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business, private-sector companies with revenues well in excess of 1 billion yuan, with solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can’t build long-term prosperity where long-term lending is unavailable.

Same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won’t go near services companies, unless of course, they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.

Chinese companies used to find it easier to absorb the cost of their high-yield debt. No longer. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.

Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, earned one-third of all profits of the entire global banking industry, amounting to $292 billion in 2013. The government is trying to force a little more competition into the market, and has licensed several new private banks. Tencent Holdings and Alibaba, China’s two Internet giants, both own pieces of new private banks.

Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China’s economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China’s economy is moving more in the direction of the market should look to a single touchstone: is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?

Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.

 

http://asia.nikkei.com/Viewpoints/Perspectives/Chinas-loan-shark-economy

Download PDF version.

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Tencent Stalks Alibaba — China’s Number Two Internet Company Quietly Takes Lethal Aim at its Number One

Leave a Comment / January 8, 2015
China's two most successful internet entrepreneurs share a last name but have very different strategies for mobile e-commerce. The future belongs to which?
China’s two most successful internet entrepreneurs share a last name but have very different strategies for mobile e-commerce. The future belongs to which Ma?

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China’s second-largest private sector company Tencent is aiming a cannon at China’s largest private sector company and new darling of the US stock markets Alibaba. Will Tencent fire? There’s a vast amount of money at stake: these two companies, cumulatively, have market cap of $400 billion, Tencent’s $140bn and Alibaba’s $260bn.

Alibaba, as most now know,  currently has China’s e-commerce market in a stranglehold, processing orders worth over $300 billion a year, or about 80% of all Chinese online sales by China’s 300 million online shoppers. Meanwhile, Tencent is no less dominant in online chat and messaging, with over 400mn users for its mobile chat application WeChat, aka “Weixin” (微信).

The two businesses appear worlds apart. And yet, they are now on a collision course. The reason is social selling, that is, using a mobile phone chat app to sell stuff to one’s friends and contacts. It’s based on the simple, indisputable notion it’s more reliable and trustworthy to buy from people you know. Facebook, Twitter, Linkedin are all quite keen on social selling in the US. But, nowhere is as fertile a market as China, because nowhere else is the trust level from buying through unknown online merchants as low.

Alibaba has accumulated most of its riches from this low-trust model at Taobao’s huge online bazaar. It is a collection of thirty million small-time individual peddlers that Alibaba can’t directly control. The result, especially in a country with no real enforceable consumer protection laws or litigation, Taobao can be a haven for people selling stuff of dubious quality and authenticity.

Chinese know this, and don’t much care for it. It’s one reason both US-listed JD.com and Amazon China both seem to be gaining some ground on Alibaba. Their strategies are similar:  to be the “anti-Taobao”, selling brand-name stuff directly, using their own buying power and inventory, their own delivery people, and a no-questions-asked return policy. Their range of merchandise, however, is far more limited than Taobao’s. Tencent in 2014 bought a significant minority stake in JD.com.

Thanks to Weixin, Tencent now has the capability directly to become Alibaba’s most potent competitor and steal away billions of dollars in transactions. Will it?

As of now, Tencent seems oddly reluctant. Even as millions of Weixin users have started using the app to buy and sell goods directly with their friends, Tencent has countered by making it more difficult. Tencent introduced limits on the number of contacts each Weixin user can add, has made sending money tricky, and has more or less banned users to include price quotes in their mobile messages. For now, Weixin users appear undaunted, and are using various ruses to get around Tencent’s unexplained efforts to limit their profit-making activities. One common one: using the character for “rice” (米） instead of the symbol for the Chinese Renminbi （元）.

This social selling through Weixin is called “Weishang” (微商) in Chinese, literally “commerce on Weixin”. It is without doubt the hottest thing in online selling now in China.

It’s hard to understand why Tencent wouldn’t passionately embrace social selling on Weixin. For now, Weixin looks to be an enormous money sink for Tencent. The Weixin app is free to download and use. What money it earns from it comes mainly from promoting pay-to-play online games. That’s small change compared to the tens of millions of dollars Tencent spends on maintaining the server infrastructure to facilitate and store the hundreds of millions of text, voice, photo and video messages sent daily on the network.

Chinese of all ages are glued to Weixin at all hours of the day. It can be hard for anyone outside China to quite fathom how deeply-woven into daily life Weixin has become in the four years since its launch. Peak Weixin usage can exceed 10mn messages per minute. With only slight exaggeration, Tencent’s founder and chairman Pony Ma explains Weixin has become like a  “vital organ” to Chinese.

It’s not just young kids. I took part in a meeting recently with a partner from KKR and the chairman of a large Chinese publicly-traded company At the end of the discussion, they eagerly swapped Weixin accounts to continue their confidential M&A dialogue.

My office is in the building next to Tencent’s headquarters in Shenzhen. I know quite a few of the senior executives. But, no one can or will articulate why Tencent, at least for now, is unwilling to use Weishang take on Alibaba. Some who claim to know say it’s because the Chinese government is holding them back, not wanting to have Tencent steal Alibaba’s spotlight so soon after its most-successful-in-history Chinese IPO in the US.

The two have sparred before. Tencent years ago launched its own copycat version of Taobao, now called Paipai. But it failed to put a dent in Alibaba’s franchise. Alibaba, in turn,  launched its own online message system to compete with Weixin. But, it’s sunk from sight as quickly as a heavy stone dropped in a deep pond.

Seen from a seller’s perspective, Weishang is fundamentally more attractive than selling on Taobao. Margins are higher, not only because Tencent charges no fees, but it’s getting much harder and more expensive to get noticed on Taobao. That’s good for Alibaba’s all-important ad revenues, but bad for merchants.

How does Weishang work? A woman, for example, buys twenty sweaters at a wholesale price, then takes a selfie wearing one. She sends this out to her 300 contacts on Weixin. Though the message includes neither the price nor much of a sales pitch, since both may be monitored by Tencent, she will often get back replies asking how to buy and how much. The sales are closed either by phone call, or through voice messaging over Weixin, with payment sent direct to the seller’s bank account.

Tencent knows Weixin is being used more and more like this, but because it’s driven the commerce somewhat underground, Tencent has no idea on the exact scale of Weishang. My guess is aggregate Weishang sales are already in the tens, if not hundreds, of millions of dollars.

Alibaba has clearly noticed. But, social selling isn’t something its Taobao e-commerce marketplace can do. Its mobile e-commerce strategy amounts to making it easy to scroll through Taobao items on a small screen. Social selling in China is and will remain Tencent’s natural monopoly.

For anyone wondering, Alibaba’s IPO prospectus from a few months ago did not mention Weishang and Weixin, and Tencent gets a single nod as one of many possible competitors. Weishang really began to gain traction only during the second half of 2014, after the main draft of the Alibaba prospectus was completed.

To those outside China especially on Wall Street, Alibaba seems to be on the top of the world, as well as the top of its game. In the last four months, it’s collected $25 billion from the IPO and another $8 billion in a bond offering. Its share price price is up 50% since the IPO. For a lot of us living here in China, the boundless enthusiasm in the US for “Ali” (as the company is universally known here) can sometimes seem a bit unhinged.

When will Tencent make its move? Why is it now so reticent to promote Weishang, or discuss its plans with the investment community? Is it busy next door to me readying a dedicated secure payment system and warranty program for Weishang purchases?

I don’t have the answer, but this being China, I do know where to look for guidance. Sun Tzu’s “The Art of War”, written 2,500 years ago, remains the country’s main strategic handbook, used as often in business as in combat. The pertinent passage, in Chinese, goes “微乎微乎，至于无形；神乎神乎，至于无声；故能为敌之司命.” In English, you can translate it as “be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness. “

In other words, don’t let your competitor see or hear you coming until its already too late.

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China’s Big Banks: learn how they overprice & misallocate loans while treating borrowers like conmen

Leave a Comment / December 11, 2014

Chinese banking loan approval process

Do you have the financial acumen to run the lending department of one of China’s giant state-owned banks? Let’s see if you qualify. Price the following loan to a private sector Chinese company.  Your bank is paying depositors 0.5% interest so that’s your cost of capital. The company has been a bank customer for six years and now needs a loan of Rmb 50mn (USD$8 mn).  The audit shows it’s earning Rmb 60mn a year in net profits, and has cash flow of Rmb 85mn.

You ask the company to provide you with a first lien on collateral appraised at Rmb 75mn and require them to keep 20% or more of the loan in an account at your bank as a compensating deposit. Next up, you ask the owner to pledge all his personal assets worth Rmb 25mn, and on top, you insist on a guarantee from a loan-assurance company your bank regularly does business. The guarantee covers any failure to repay principal or interest. What annual interest rate would you charge for this loan?

If you answered 5% or lower,  you are thinking like a foreigner. American, Japanese or German maybe. If you said 13% a year, then you are ready to start your new career pricing and allocating credit in China. At 10% and up, inflation-adjusted loan spreads to private sector borrowers in China are among the highest in the world, particularly when you factor in the over-collaterallization, that third-party guarantee and fact the loan is one-year term and can’t be rolled over. As a result, the company will actually only have use of the money for about nine months but will pay interest for twelve. Little wonder Chinese banks have some of the fattest operating margins in the industry.

Chinese private businessmen are paying too much to borrow. It’s a deadweight further slowing China’s economy. We are quite keen, by the way,  on private debt investing in China.

The high cost of borrowing negatively impacts corporate growth and so overall gdp growth. It is also among the more obvious manifestations of an even more significant, though often well-hidden, problem in China’s economy: the fact that nobody trusts anybody.  This lack of trust acts like an enormous tax on business and consumers in China, making everything, not just bank credit, far more expensive than it should be.

Online payment systems, business contracts, visits to the doctor, buying luxury products or electronics like mobile phones or computers: all are made more costly, inefficient and frustrating for all in China because one side of a transaction doesn’t trust the other. One example: Alibaba’s online shopping site, Taobao, will facilitate well over USD$200bn in transactions this year. Most are paid for through Alipay, an escrow system part-owned and administered by Alibaba. Chinese shoppers are loathe to buy anything directly from an online merchant. They generally take it as a given that the seller will cheat them.

Most of the world’s computers and mobile phones are made in China. But, Chinese walk a minefield when buying these products in their own country. It’s routine for sellers to swap out the original high-quality parts, including processors, and replace them with low-grade counterfeits, then sell products as new. Chinese, when possible, will travel outside China, particularly to Hong Kong, to buy these electronics, as well as luxury goods like Gucci shoes and Chanel perfume. This is the most certain way to guarantee you are getting the genuine article.

In the banking sector, loans need to have multiple, seemingly excessive layers of collateral, as well as guarantees. Banks simply do not believe the borrower, the auditors, their own in-house credit analysts, or the capacity of the guarantee firms to pay up in the event of a problem.

Disbelief gets priced in. This is the reason for the huge loan spreads in China. Banks regard their own loan documentation as a work of fiction. It stands to reason that if a company’s collateral were solid and the third-party guarantee enforceable, then the cost to borrow money should be at most a few points above the bank’s real cost of capital. Instead, Chinese companies get the worst of all worlds: they have to tie up all their collateral to secure overpriced loans, while also paying an additional 2%-3% a year of loan value to the third-party credit guarantee company for a guarantee the bank requires but treats as basically worthless.

In the event a loan does go sour, the bank will often choose to sell it to a third party at discount to face value, rather than go to court to seize the collateral or get the guarantee company to pay up. The buyer is usually one of the state-owned asset recovery companies formed to take bad debts off bank balance sheets. Why, you ask, does the bank require the guarantee then fail to enforce it? One reason is that Chinese private loan-assurance companies, which usually work hand-in-glove with the banks,  are usually too undercapitalized to actually pay up if the borrower defaults. Going after them will force them into bankruptcy. That would cause more systemic problems in China’s banking system.

Instead, the bank unloads the loan and the asset recovery companies seize and sell the only collateral they believe has any value, the borrower’s real estate. The business may be left to rot. The asset management companies usually come out ahead, as do the loan guarantee companies, which collect an annual fee equal to 2% to 3% of the loan value, but rarely, if ever, need to indemnify a lender.

Don’t feel too sorry for the bank that made the loan. Assuming the borrower stayed current for a while on the high interest payments, the bank should get its money back, or even turn a profit on the deal. Everyone wins, except private sector borrowers, of course. Good and bad like, they are stuck paying some of the highest risk-adjusted interest costs in the world.

When foreign analysts look at Chinese banks, they spend most of their time trying to divine the real, as opposed to reported, level of bad debts, devising ratios and totting up unrealized losses. They don’t seem to know how the credit game is really played in China.

Most of the so-called bad debts, it should be said, come from loans made to SOEs and other organs of the state. Trust is not much of an issue. SOEs and local governments generally don’t need to pledge as much collateral or get third-party guarantees to borrow. A call from a local Party bigwig is often enough. The government has shown it will find ways to keep banks from losing money on loans to SOEs. The system protects its own.

Chinese banks should be understood as engaged in two unrelated lines of business: one is as part of a revolving credit system that channels money to and through different, often cash-rich, arms of the state. The other is to take in deposits and make loans to private customers.  In one, trust is absolute. In the other, it is wholly absent.

Many Chinese private companies do still thrive despite a banking system that treats them like con artists, rather than legitimate businesses with a legitimate need for credit. The end result: the Chinese economy, though often the envy of the world,  grows slower and is more frail than it otherwise would be. Everyone here in China is paying a steep price for the lack of trust, and the mispricing of credit.

 

 

China juices liquidity, and risk, at OTC exchange — Reuters

Leave a Comment / June 24, 2016

Reuters

China juices liquidity, and risk, at OTC exchange

By Pete Sweeney

SHANGHAI August 22 Thu Aug 21, 2014 5:10pm EDT

(Reuters) – Chinese brokerages will start making markets next week on China’s New Third Board, its leading over-the-counter (OTC) exchange but one long derided as a dead-end market populated by small little-known, opaquely managed firms.

The move has revitalized interest and trading volumes have exploded, but analysts warn of significant risk.

Most of the 66 Chinese brokerages so far approved to make markets – a business that requires deep cash reserves and sophisticated risk management skills – have little experience.

Market makers quote both a buy and sell price and guarantee share availability by holding shares themselves in inventory, which requires careful real-time management.

For brokerages it means extra profits, while China’s policymakers hope the liberalization will boost liquidity in an exchange that can provide capital for small innovative firms, needed for the next phase of economic expansion.

But, analysts fear that brokerages inexperience coupled with inadequate disclosure by listed companies could led to trouble for an exchange already saddled with image problems.

“Like all OTC markets – including… America’s Bulletin Board and Pink Sheets – China’s Third Board suffers from inherent fundamental flaws,” said Peter Fuhrman, chief executive at China First Capital.

“Liquidity and valuations are persistently low and disclosure is spotty. If it was designed to be a solution to the problem of erratic mainstream IPO policy and approvals on China’s main Shenzhen and Shanghai stock exchanges, the Third Board must be judged a major disappointment.”

Regardless of critics, trading volumes on the exchange soared almost 700 percent in May when Chinese media first reported the advent of market-makers, ChinaScope Financial data shows. Foreign investors are unable to trade on the exchange.

A Reuters analysis of daily data from the National Equities Exchange and Quotations (NEEQ), which runs the New Third Board, shows that August volumes are set to surpass May’s record. Transactions worth 1.16 billion yuan ($188.63 million), as of Aug. 19, were nearly double July’s total, while the volume of shares traded has more than tripled month-on-month.

SMALL CAP CELEBRATION

Smaller private companies in China are the country’s biggest aggregate employers and generators of GDP, but they have difficulty getting bank loans and even more difficulty getting regulatory approval to list on major markets or issue bonds.

However, while dozens of local governments have created OTC markets to help match companies with investors, the lack of market makers and lack of a clear upgrade path to major exchanges has caused most firms and investors to steer clear.

But that may be about to change.

“The expectation is that the Third Board can be an entree onto the growth enterprise board for select small companies,” said Brian Ingram, chief investment manager at Russell Ping An Investment Management.

“If the board does serve that purpose, it’s likely to see pretty rapid growth, and the catalyst for that growth is the fact that regulators are allowing brokerage houses to serve as market makers.”

Brokerages hope it will boost in profits, something they need badly having struggled since 2010 as investors steadily switched out of Chinese stocks, among the world’s worst performers, in favor of housing and high-yielding wealth management products.

SMALL-CAP FEEDING FRENZY

Chinese investors enthusiastically trade small, volatile tickers listed on Shenzhen’s ChiNext growth board, so some predict a revitalized OTC board will attract similar speculative interest, further supporting liquidity.

However, sustained interest from both investors and companies depends on whether regulators formally commit to allowing companies on the New Third Board upgrade to ChiNext.

“We’re now considering listing on the New Third Board, but we are waiting for policy confirmation that we can upgrade to ChiNext,” said Cui Lijun, deputy general manager at robotics firm LEN in Shenzhen.

Similar experiments have disappointed in the past, such as the hard-currency-denominated “B-share” board. Speculators bought B-shares hoping they would ultimately be upgraded to yuan-denominated A-shares, but in the end only a few companies were allowed to transfer, leaving the rest stranded.

CALLS FOR CAUTION

The chequered history of OTC markets in China and abroad, especially with regards to disclosure standards, also has many calling for caution.

In the late 2000s, small Chinese companies began listing on American OTC boards, and some managed to upgrade to major exchanges such as NASDAQ. But many were subsequently found to be riddled with accounting irregularities, causing a swathe of delistings.

Given this history, it is unclear whether regulators want to expand the aggregate OTC market or consolidate it.

Out of all of China’s 26 OTC markets, the New Third Board is the only one that companies from anywhere in China can list on, and it will now be the only one where making markets will be allowed.

Some analysts said that this means the government may be elevating the Third Board, so it can then kill off the rest.

But Zhang Yunfeng, the head of Shanghai’s rival OTC market, said in an interview published in China’s Securities Times on Wednesday that he doesn’t feel threatened.

“I’m not optimistic about the market making institution … if there’s not enough base liquidity, market making will have a hard time enabling market performance.”

www.reuters.com/article/2014/08/21/us-china-markets-otc-idUSKBN0GL26920140821

Download PDF version.

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China’s rise enters a more challenging phase, where bold ambitions confront stubborn, often centuries-old obstacles

Leave a Comment / August 5, 2014

China First Capital 2014 Survey cover

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China’s economy and society have both reached levels of wealth and development that were unimaginable 30 years ago. What comes next? How can China continue to push forward, against some deep-seated problems, including how to generate globally-competitive innovation, how to sort out land ownership, how to attract and reward global investment flows? These issues are examined in detail in the new research study published by China First Capital.

The new report is titled ” China Survey 2014: The Rise Continues, New Directions & Challenges“. Copies may be downloaded by clicking here or from the research reports page of the company’s website.

China’s economy remains vibrant and fast-evolving. Many of the Fortune 500 successes stories of recent years – KFC, P&G, Coca-Cola – are finding it harder and harder to keep winning in the China market. As they lose share, other companies are gaining, both domestic and international. The report looks at this transformation through the vantage point of China First Capital’s rather long experience working in China,  alongside some talented CEOs in both domestic and global corporations, the incumbents and the disrupters both.

Investing successfully in China, either through the stock market or through M&A, also remains challenging. But, it’s worth the strain, the report asserts, since no other country can rival China today in terms of both the number and scale of money-making opportunities.

The new China First Capital report discusses these broad trends, and also examines the following in depth:

  •  is China’s investment community (PE and VC firms, stock market investors)  over-allocating now to mobile services and online shopping;
  •  an assessment of the serious challenge facing traditional shopping mall operators and retailers mainly because of competition from soon-to-IPO Alibaba’s online shopping giant;
  • a sober analysis of actual disappointing state of China’s high-tech industry;
  • how China triumphed over India, and won the battle as the world’s best and biggest Emerging Market,
  • why 3M may be the most successful American company in China, but flies so far beneath everyone’s radar

Some of the contents have already been published here on this blog and on Seeking Alpha.

The report’s core conclusion is that China has come a long way and in raw terms is certainly the most successful emerging economy of all time. But, it needs to become more innovative, generate more globally important technology breakthroughs, not just copycatting. There’s no absence of hype around about how China is poised to become a global technology powerhouse. The report, though,  cites China’s failure to serially produce an aircraft engine as a concrete, if not often talked-about, reminder of its technology frustrations and limitations.

 

 

Neue Zurcher Zeitung Interview

Leave a Comment / December 5, 2014

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Monday’s “Neue Zurcher Zeitung” of Switzerland published an article based on the interview I gave last week while in London with the newspaper’s financial editor Christof Leisinger. For those whose German is up to the task, click here to read the article in full.

To get a flavor of what we discussed, here are some of the quotes, in English:

“China has the world’s second largest economy and capital market. GPD growth and corporate earnings are both growing far faster than in OECD countries. And yet, global institutional capital is in almost all cases seriously underweight China. How to explain this? Simple, there are just too few attractive and legal ways for international capital to invest in China.

“The Chinese companies quoted in the US and Hong Kong mainly come from two unrepresentative pools: large, slower-growing Chinese state-owned companies, and internet and mobile services “concept” stocks often with limited revenues and profits. The powerful engine of long-term economic growth in China, its millions of successful private sector entrepreneur-founded businesses serving domestic market, are almost all off-limits to non-Chinese investors. To invest, you need state approval to buy Renminbi and later permission to convert back into dollars, Euros or other freely-tradable currencies.

“China no longer especially needs or wants Western capital to finance its economic growth. The best way now to invest in China, to increase allocation there,  is probably through M&A, by putting money into US or European companies that are aggressively acquiring good Chinese private sector ones.”

“Overall, the country is doing an excellent job managing the transition from export-reliance to domestic consumption, a economic challenge Germany is still struggling with. The Chinese economy has undergone enormous structural change over the last five years, most of it positive, with more and more of economic activity coming from the private sector, rather than state-owned one, from producing and selling products to satisfy the needs of  China’s 1 billion consumers rather than those of Wal-Mart shoppers in the US.

“On the macro level I do not expect any big change anytime soon, no free convertibility for the Renminbi. But, more quietly and pragmatically, the Chinese government has solved a rather large problem related to this, by making it legal and simple now for every Chinese citizen to use Renminbi to buy up to $50,000 a year in dollars, to pay for travel, educating their children, or buy shares or other assets outside China. In other words, the capital account remains closed, but Chinese individually now have a lot of the benefits of free exchange between dollars and Renminbi. It’s one of the reasons the Champs d’Elysees and Bond Street are jammed with Chinese tourists.”

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China’s SOEs attract PE interest — Private Equity International Magazine

Leave a Comment / March 7, 2014

Private Equity International Magazine

www.peimedia.com

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China’s state-owned enterprise promise big returns for PE investors, as well as a big challenge.

By: Clare Burrows–

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In 2013, private equity investment in China dropped to just $4.5 billion – about 47 percent below the equivalent figure for 2012, according to data from Thomson Reuters. Since China’s dry powder level was estimated at $59 billion at the end of 2012, it’s clear that China’s GPs need to find new ways to deploy the vast amounts of capital raised during better times.–

What seems to be catching the industry’s eye more than ever are the country’s state-owned enterprises:large, government-controlled organisations, many of which are in dire need of restructuring. While state-owned enterprises account directly or indirectly for 60 percent of China’s GDP, according to research by China First Capital, almost 100 percent of institutional capital, especially private equity, has
been invested into China’s privately-owned sector.

However, as the number of traditional opportunities falls, “this may leave investing in SOEs as the best, largest and most promising new area for private equity investment,” Peter Fuhrman, chairman and chief executive at China First Capital suggests.–

And, some industry sources ask: what better target for private equity than these bloated, inefficient giants, which the newly-appointed Chinese government is apparently so keen to reform? SOEs are highly compliant when it comes to tax and accounting laws (a rare phenomenon among China’s privately-owned companies). Better still, they’re a bargain – because China’s State-owned Assets Supervision and Administration Commission (SASAC) regulates their price based on net asset value.–

“If you have a highly profitable SOE that has very low net assets, you can potentially buy it at incredibly low P/E multiples,” Fuhrman says. With one deal China First is advising on, 51 percent of the business is being offered at 2x EBITDA, he adds. China First is currently acting as an investment banker for five of China’s largest SOEs, including China Aerospace, China State Construction, China Huadian, Wuliangye Group and Shandong Energy.

Click here to read full article

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Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

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PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.– – –

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

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China’s Logistical Nightmare

1 Comment / November 14, 2013

China First Capital blog logistics in China

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China is modeling itself after the wrong part of the American economy. The money, the rhetoric and the policies are all focused on trying to replicate America’s lead in high-technology and innovation. Instead, China would be long-term much better off and its citizens enjoy immediate higher living standards if it copied something far more mundane from the US,  its distribution and logistics.  If China’s $9 trillion economy has an Achilles Heel, this is it. It simply costs too much to get things into consumers’ hands.

Wholesale layer is piled onto wholesale layer, with margin and fees extracted at every step. Fixers, expediters, overlookers all take a cut. Trucks are too small, tolls too high, warehouses too small, and road traffic too congested in major cities. Commercial and retail rents are high, relative to per capita income level. In China, there is enough “friction” in every retail transaction to start a bonfire.

Logistical costs and bottlenecks are the single biggest reason why so many goods made in China are sold at higher prices than in the US. This has more real-world consequences for average Chinese consumers than the level of the dollar-Renminbi exchange rate. It is logistics costs, all the stickiness and expense of getting products to market, that is most to blame for holding back the buying power, and so spending impulses, of Chinese consumers. Middlemen live well in China. Consumers less so.

It is cheaper, in many cases, to get a product made in China onto a container ship in Shanghai, offload it in Long Beach, truck it across the US, and then stock it on a shelf at a Wal-Mart in Georgia then it is to put the same product in front of Chinese consumers in a Wal-Mart in China. High taxes don’t help. China’s VAT, applied to most things sold at retail,  is set at a higher level than most sales taxes in the US. Another factor: retail competition as Americans know it is also largely absent in China. Stores don’t compete much on price in China. Wal-Mart won’t say, but it’s a fair assumption its margins in China are at least double those in the US.

But, high consumer prices in China are mainly the product of the high handling charges. A simple example. I eat a lot of fruit.  Most fresh fruit grown in China costs as much or more in supermarkets here than the same fruit grown and sold in the US.

Apples sell for around Rmb 6 (95 cents) per pound and up in China. The apple farmer gets around Rmb 1 per pound. The rest is liberally spread among all those standing between apple tree and my mouth.

Adjusted for purchasing power, Chinese average income levels are around 1/6th the US’s. So, that Chinese apple sells for equivalent, in US terms, of $6 a pound. That amounts to a lot of money per apple being shared by people other than the grower and the eater. How much? Chinese eat a lot of apples. In fact, almost half of all apples grown in the world are eaten in China, ten times more than total US consumption.

I met the boss of one of China’s largest apple shipping and packaging companies. Outside of China, this is a razor-thin margin business. But, the Chinese apple packer and shipper has profit margins well above 10%.

One of the most expensive links in the Chinese domestic supply chain are road tolls. China’s are among the most costly, per kilometer traveled, anywhere in the world. Trucks carrying agricultural products don’t pay tolls. Anything else moving along China’s highway system pays full freight. Depending where you are in the country, tolls run as high as 25 cents a mile for passenger cars. Trucks pay triple that. It all, of course, ends up being passed along to consumers.

To amortize the tolls, truckers overload their vehicles. This burns more fuel, degrades roadways (justifying still higher tolls), and makes loading and unloading more time-consuming and so more costly. According to the boss of a large long-distance shipping company I talked to, his trucks are routinely pulled over by traffic police and made to pay various on-the-spot fines. This can double the amount paid in tolls.

Everything about the logistics industry in China acts as a sponge soaking up consumers’ cash. The one exception: Shunfeng Express （顺丰快递）.  Little known outside China, Shunfeng Express is China’s most successful private shipping and delivery companies. It alone proves that logistics in China doesn’t need to be wasteful, expensive and inefficient.

Shunfeng is modeled after Fedex, DHL and UPS, but operates on a scale, and at prices, that would be unimaginable to these global giants. Shunfeng is a secretive outfit. Not much is publicly disclosed. The founder lives in Hong Kong, but comes originally from the mainland.  It was started in 1993, and according to some media reports, its net income in 2010 of Rmb 13 billion ($2.1 billion). That may be a stretch, but Shunfeng is doing a lot right and deserves whatever profit it keeps.

Shunfeng picks up and delivers documents, packages and some bulk freight between cities in China. It charges a fraction of what Fedex or UPS do in the US. These US companies are mainly prohibited to operate in China’s domestic delivery market. I’m not sure they’d be so eager. For next-day document delivery within a city, Shunfeng charges under $2. Delivery to other cities: $3. If you want to move a few kilos of freight, Shunfeng not only ship it, but will come and package it for you. That part is free. The shipping usually works out to less than $5 a kilo.

One of the main reasons Alibaba’s Taobao has become so successful in China is that Shunfeng ships Taobao purchases cheaply and efficiently across China. Taobao, which operates like a cross between Amazon Marketplace and eBay, will likely facilitate transactions worth around USD$100 billion this year. A lot of that will get shipped and delivered by Shunfeng.

They have an army of delivery guys. Most larger office buildings in major cities have one permanently stationed inside. You call for a pickup and the Shunfeng guy arrives within minutes. Most letters and packages get moved around by either electric motorcycle or jet. It leases its own aircraft to fly stuff around within China.

Shunfeng doesn’t do cross-country trucking. This is one big reason Shunfeng are so efficient and so cheap. Anything that moves by truck in China is going to have multiple hands in the till, and so end up costing consumers too much.

Shunfeng has achieved its massive scale and now well-known brand in China without raising capital from the stock market, or bringing in outside professional investors until three months ago. There are few private companies in China I admire more, and who are doing more to benefit the average consumer in China. I wish I could invest. For the good of every consumer in China, Shunfeng should continue to grow, continue to expand the range of what it handles in China. That will do a lot to unstick China’s logistical logjam.

 

 

Chinese IPOs Try to Make a Comeback in US — New York Times

Leave a Comment / June 24, 2016

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I.P.O./Offerings

Chinese I.P.O.’s Try to Make a Comeback in U.S.

BY NEIL GOUGH

HONG KONG — Chinese companies are trying to leap back into the United States stock markets.

The return, still in its early days and involving just a handful of companies, comes after several years of accounting scandals that pummeled their share prices and prompted scores of companies to delist from markets in the United States.

But the spate of recent activity suggests investors may be warming once more to Chinese companies that seek initial public offerings in the United States.

Qunar Cayman Islands, a popular travel website owned by Baidu, China’s leading search engine company, began trading on Nasdaq on Friday and nearly doubled in price. On Thursday, shares in 58.com, a Chinese classified ad website operator that is often compared to Craigslist, surged 42 percent on the first trading day in New York after its $187 million public offering.

The question now — for both American investors and the companies from China waiting in the wings to raise money from them — is whether these recent debuts are an anomaly or have truly managed to unfreeze a market that was once a top destination for Chinese companies seeking to list overseas.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm based in Shenzhen, China, said that for both sides, the recent signs of a détente between American investors and Chinese companies is “a matter of selectively hoping history repeats itself.”

“Not the recent history of Chinese companies dogged by allegations, and some evidence, of accounting fraud and other suspect practices,” he added. “Instead, the current group is looking back farther in history, to a time when some Chinese Internet companies with business models derived, borrowed or pilfered from successful U.S. companies were able to go public in the U.S. to great acclaim.”

That initial wave of Chinese technology listings began in 2000 with the I.P.O. of Sina.com and later featured companies like Baidu, which has been described as China’s answer to Google. In total, more than 200 companies from China achieved listings on American markets, raising billions of dollars through traditional public offerings or reverse takeovers.

But beginning about 2010, short-sellers and regulators started exposing what grew into a flurry of accounting scandals at Chinese companies with overseas listings. In some cases, such accusations have led to the filing of fraud charges by regulators or to the dissolution of the companies. Prominent examples include the Toronto-listed Sino-Forest Corporation, which filed for bankruptcy last year after Muddy Waters Research placed a bet against the company’s shares in 2011 and accused it of being a “multibillion-dollar Ponzi scheme.”

Concerns about companies based in China were reinforced in December when the United States Securities and Exchange Commission accused the Chinese affiliates of five big accounting firms of violating securities laws, contending that they had failed to produce documents from their audits of several China-based companies under investigation for fraud.

In response, American demand for new share offerings by Chinese companies evaporated, and investors dumped shares in Chinese companies across the board. It became so bad that the tide of listings reversed direction: Delistings by Chinese companies from American markets have outnumbered public offerings for the last two years.

Despite the renewed activity, it is too early to say whether Chinese stocks are back in favor. The listing by 58.com was only the fourth Chinese public offering in the United States this year, according to Thomson Reuters data. LightInTheBox, an online retailer, raised $90.7 million in a June listing but is trading slightly below its offering price. China Commercial Credit, a microlender, has risen 50 percent since it raised $8.9 million in August. And shares in the Montage Technology Group, based in Shanghai, have risen 41 percent since it raised $80.2 million in late September.

Still, this year’s activity is already an improvement from 2012, when only two such deals took place, according to figures from Thomson Reuters. Last month, two more Chinese companies — 500.com, an online lottery agent, and Sungy Mobile, an app developer — submitted initial filings for American share sales.

But the broader concerns related to Chinese companies have not gone away. In May, financial regulators in the United States and China signed a memorandum of understanding that could pave the way to increased American oversight of accounting practices at Chinese companies. But the S.E.C.’s case against the Chinese affiliates of the five big accounting firms remains in court.

The corporate structure of many Chinese companies is another unresolved area of concern. Because foreign companies and shareholders cannot own Internet companies in China, both 58.com and Qunar rely on a complex series of management and profit control agreements called variable interest entities. Whether such arrangements will stand up in court has been a cause for concern among foreign investors in Chinese companies.

And short-sellers continue to single out companies from China, often with great success.

In a report last month, Muddy Waters took aim at NQ Mobile, an online security company based in Beijing and listed in New York, accusing it of being “a massive fraud” and contending that 72 percent of its revenue from the security business in China last year was “fictitious.”

NQ Mobile has rejected the accusations, saying that the report contained “numerous errors of facts, misleading speculations and malicious interpretations of events.” The company’s shares have fallen 37 percent since the report was published.

(http://dealbook.nytimes.com/2013/11/01/chinese-i-p-o-s-attempt-a-comeback-in-u-s/?_r=1)
 
Download PDF version.
 

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Investors Vs. Asset Managers: A Dysfunction at the Heart of China Private Equity

1 Comment / September 12, 2013

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Assuming the same level of risk, would you rather make $100 from investing $10 or from investing $50? Easy, right? Who wouldn’t choose to make ten times your money, rather than just double it? There is one group I know. Private equity firms active in China. At least some of them. They care more about the amount they can invest in a deal than the profits they stand to make.

The illogic at work here is the direct result of some particular, not very appealing characteristics,  of the PE industry in China. PE firms lately have more confidence in their ability to raise money than to invest it profitably by achieving a timely exit. To raise money, though, a PE firm needs first to spend most of what it already has. Result: a rush to get money out the door and parked in deals.

In industry parlance, “check size” is often more important than potential risk-adjusted returns.This is one reason for the recent rash of “take private” PtP deals of Chinese companies quoted in the US. (See previous articles, including here, here, here. ) The transactions seem to me ill-considered. PEs have invested billions of dollars in such deals but there is not a single successful example they can point to of such PtP deals done in the US making money for investors. This must be a PE industry first — so much LP money put at risk against an investment idea that is totally unproved.

Who’s most harmed from focus on “check size” over deal quality and prospective returns? Of course it’s the LPs whose money is put into these deals. They want and need high returns, not bigger deals done using their money to aid PE firms’ future fund-raising.

But, Chinese entrepreneurs also suffer in this environment, because many PE firms now simply won’t look at deals where they can’t invest at least $25mn for around 25% of the company. There are few deals out there in that size range, meaning deserving entrepreneurs can’t find investors.

The big picture here: PE in China has become more and more a business dominated by asset managers not investors. How to tell the two apart? An asset manager enjoys the comfort and certainty of making a steady 2% a year managing other people’s money. The more money they raise, the more money they keep. Good markets or bad, the money keeps rolling in.

An investor, on the other hand, is a whole different animal. They share some DNA with the entrepreneurs they back. They love the sport of finding and evaluating deals, spotting where big money can be made, putting money at risk. When it works, they make big sums for their investors, and keep a nice chunk themselves.

Needless to say, LPs give money to PE firms in hopes they have chosen investors not asset managers. PE firms know this, of course, and tailor their money-raising pitch accordingly. They stress their deal-making prowess, not the fact that over the life of a typical 10-year fund, an LP will start with a 20% cumulative loss, because of the typical annual management fee deductions.

In China, it used to be fairly easy to make money in PE. But, over the last three years, returns began to head south. More recently,  over the last 18 months, the performance has mainly been dismal, with few successful deals exiting with big profits. It’s getting harder and harder for LPs to make money in China PE, after those accumulated management fees have been deducted.

But, there’s a time lag — as well as an information asymmetry — at work here. While recent performance has been, on the whole, lousy, there’s still appetite among LPs to allocate more money to China. A big reason is that China’s economy, and capital markets, are both the second-biggest in the world. Most LPs are seriously underweight China and want to change that.

And so we arrive at the current paradoxical situation, where it’s still comparatively easier to collect money to invest in China than to make money deploying it. Now, of course, PE firms can only succeed in raising capital if they can point to some successful past deals. Here too there’s an information asymmetry at work. Many PE firms did well from 2005-2010, and so their fund-raising documents emphasize deals done during this era. But, the game has changed out of all recognition since then.

Few, if any, PE firms have shown they can continue to earn investors good money when markets become less accommodating. It’s no longer possible to play the game of valuation arbitrage, of investing in China deals at single digit p/e multiples, and exiting them soon after at 5-10 times higher multiples through an IPO.

Earning a profit on an investment takes preparation, luck and time. Making money by convincing people to pay you a fee to manage theirs, by contrast, is a much simpler proposition, as well as a no-lose one.

And so the gulf widens between the objectives of PE firms and the fiduciary responsibilities and performance goals of the institutions whose money they manage.

This can be a problem everywhere in the PE and VC industry, as well as more broadly wherever people get paid to manage assets owned by someone else. (See principal-agent dilemma.)   But, it’s probably especially pernicious in China PE.

The industry is staffed mainly be ex-investment bankers, who by background and temperament understand more about fee-based, than performance-based, compensation. Few have a background of actually managing a company, investing its capital to produce a return. Without this first-hand understanding, it’s far harder as an investor to plot how to make an operating business more valuable. The result: PE firms in China will often opt for an easier path: making money by raising money from, and managing for,  other financial professionals.

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China SOE Accounting — BAAP Not GAAP Applies

Leave a Comment / December 15, 2013

China SOE accounting–

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If the last two years of crisis in investing in Chinese companies proves anything, it’s that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones,  if professional short-sellers like Muddy Waters, as well as securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones,  live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise (“SOE”). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside,  is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That’s because SOEs also operate by their own set of accounting standards. I call it “Chinese BAAP“, or “bureaucratically accepted accounting principles“. This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC’s job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management’s weekend gambling junket to Macao. This isn’t to say that such things can’t occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I’ve personally spent during 2013 studying and complying with SOE payment procedures, I’d probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn’t impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company’s expenses and revenues. It’s also to make sure all of last year’s assets, plus any new ones bought during the current audit year,  can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to,  an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn’t know how to perpetrate accounting fraud if they were being paid to do so. They’ve grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on,  would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.