Chinese SME

Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

1 Comment / July 23, 2013

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

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M&A in China — New China First Capital Research Report, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China”

Leave a Comment / June 18, 2013

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M&A in China is entering a new, more promising phase. At no previous time was the environment as favorable to identify and close, at attractive valuations, the acquisition of a profitable, high growth, well-run, larger private business in China.

This is the conclusion of a recently completed research study by China First Capital, as part of our M&A advisory work. (An abridged copy of the report is available by clicking here.) The report is titled, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China: Sourcing and executing successful corporate acquisitions and buyouts from unexited PE deals in China“.

The industrial logic of doing acquisitions in China has never been in doubt. The scale, high annual growth rate and fragmented nature of China’s domestic economy all create a powerful attraction for control investors. The challenge has traditionally been a negative selection bias on the sell-side, that the Chinese companies available for purchase are often troubled,  state-owned, inefficient or poorly-managed. China’s best corporate assets, its larger private companies, were not previously available to control investors.

As a result, M&A in China, for all the predictions of an impending take-off, has never gotten into gear. The theory behind most deals, if there was one, was to tie two stones together and see if they float.

The reason for the positive change in the environment for control deals in China is the serious degradation in the environment for minority ones. Specifically, China’s private equity industry is in a state of deepening crisis. Having financed the growth of many of China’s best private companies, the PE firms are now finding it increasingly difficult to engineer a liquidity event before the expiry of their fixed fund life. They are emerging as distress sellers of desirable assets — in this case, strong PE-backed companies that are left without any other viable means for investors to exit.

As elaborated in earlier research reports from China First Capital, (read  here, here, here) there is a large overhang of over 7,500 unexited private equity deals in China. Most of these deals were done on the expectation of exiting through an IPO within a few years. That was always statistically improbable. In no year did more than 150 PE-backed Chinese private companies IPO.

An IPO has gone from statistically improbable to virtually unattainable. This is not only impacting the thinking of PE firms, but of the entrepreneurs they back as well. The exit math for private company bosses in China has changed dramatically over the last 12 months. M&A looks more and more like the only viable path to exit.

For business owners, the challenge to getting a deal done are both psychological and practical. First, owners must accept that valuations are way below where they hoped them to be, as well as well below the level two years ago, when they topped out at over 100 times last year’s net income. Second, the number of companies looking to sell will quickly begin to outnumber the qualified and capable acquirers. This will put further downward pressure on valuations.

In other words, for private company bosses looking for a liquidity event, the pressure to consider selling the business is mounting. For investors, owners and acquirers, the result is the beginnings of a genuine market for corporate control for private sector businesses in China.

The new China First Capital report is directed towards all three classes of potential acquirers — 1) global businesses seeking China market entry; 2) corporate acquirers seeking market or margin expansion in China through strategic or tuck-in acquisitions; 3) China domestic or global buyout firms seeking quality operating assets that can be built up and sold.  Their methods, timetable, metrics and deal targets will often differ. But, all three will find the current situation in China more suitable than at any previous time for executing M&A transactions of USD$100mn and above.

While the number of attractive targets is increasing, the complexities of doing M&A in China remain. The invested PE firms are almost always minority investors. A control transaction will need to be structured and staged to incentivize the owner to sell at least a portion of his holding alongside the PE firm, and then likely remain for at least several years at the helm.

The report offers some possible deal structures and timing mechanisms, included using “blended valuation” to determine price. It also charts the all-important  “when does cash enter my pocket” timing from the perspective of a selling majority owner.

PE investment in China, the report concludes,  has altered permanently the business landscape in China. It has also prepared the ground for a surge now in M&A activity.

Over $150 billion in PE capital was invested to propel the growth of over 10,000 private businesses. PE finance helped create a more dynamic and powerful private sector in China. In quite a number of cases, the PE-invested businesses have emerged as industry leaders in their sectors in China, highly profitable, innovative, fast-growing, with revenues of $100mn and above.

These companies have the scale and established market presence to permit a strategic acquirer to substantially increase its activity in China, extending product range, customer relationships, distribution channels. For buyout firms or corporate acquirers, taking over a PE-invested company should offer satisfactory financial returns. Buyout ROE can be significantly enhanced in certain cases by using leverage to finance the acquisition.

The supreme irony is that this moment of opportunity in domestic M&A comes at the same time quite a number of PE firms are pursuing highly questionable “take private” deals involving troubled Chinese companies listed on the US stock market. (See earlier blog posts here, here, here, here.) The risks, and prices paid, are far higher than doing well-targeted domestic M&A in China.

When junk is priced like jewels — and vice versa — is there any doubt where the smart money should go?

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The Fatal Flaws of China “Take Private” Deals on the US Stock Market

Leave a Comment / April 25, 2013

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Every one of the twenty  “take private” deals being done now by private equity firms with Chinese companies listed in the US, as well as the dozens more being hotly pursued by PE firms with access to a Bloomberg terminal, all suffer from the same fatal flaws. They require the PE firm to commit money, often huge loads of money, upfront to companies about which they scarcely know anything substantive. This turns the entire model of PE investing on its head. The concept behind PE investment is that a group of investment professionals acquires access to company information not readily available to others, and only puts LPs’ money at risk after doing extensive proprietary due diligence. This is, after all,  what it means to be a fiduciary — you don’t blow a lot of other people’s money on a risky deal with no safeguards.

And yet, in these “take private” deals, the only material information the PE firms often have at their disposal before they start shoveling money out the door are the disclosure documents posted on the SEC website. This is the same information available to everyone else, the contents of which will often reveal why it is that these Chinese-quoted companies’ share prices have collapsed, and now trade at such pathetically low multiples. In other words, professional investors in the US read the SEC filings of these Chinese companies and decide to dump the shares, leading to large falls in the share price. PE firms, with teams based in Asia, download the same documents and decide it’s a buy opportunity, and then swoop in to purchase large blocks of the company’s distressed equity, then launch a bid for the rest of the free float. There’s something wrong here, right?

Let’s start with the fact that these Chinese companies being “taken private” are not Dell Inc. The reliability, credibility, transparency of the SEC disclosure documents are utterly different. In addition, their CEOs are not Michael Dell. There is as much similarity between Dell and Focus Media, or Ambow Education as there is between buying a factory-approved and warrantied used car, with complete service history, and buying one sight-unseen that’s been in a wreck.

The Chinese companies being targeted by PEs have, to different degrees, impenetrable financial statements, odd forms of worrying related party transactions,  a messy corporate structure that in some cases may violate Chinese law, and audits prepared by accounting firms that either are already charged with securities violations for their China work by the SEC (the Big Four accountants) or a bunch of small outfits that nobody has ever heard of.  It is on the basis of these documents that take private deals worth over $5 billion are now underway involving PE firms and US-quoted China companies.

Often,  the people at the PE firm analyzing the SEC documents, and the PE partners pulling the trigger, are non-native English speakers, with little to no experience in the world of SEC disclosure statements, the obfuscations, the specialist nomenclature, the crucial arcana buried in the footnotes. (I spent over nine years combing through SEC disclosure documents while at Forbes, and still frequently read them, but consider myself a novice.) The PE firms persuade themselves, based on these documents, that the company is worth far more than US investors believe, and that their LPs’ cash should be deployed to buy out all these US shareholders at a premium while keeping the current boss in his job. Are the PE firms savvy investors? Or what Wall Street calls the greater fool?

The PE firms, to be sure, would probably like to have access to more information from the company before they start throwing money around buying shares.  They’d like to be able to pour over the books, commission their own independent audit and legal DD, talk to suppliers and customers — just as they usually insist on doing before committing money to a typical China PE deal involving a private company in China. But, the PE firms generally have no legal way to get this additional — and necessary — information from the “take private” Chinese companies before they’re already in up to their necks. By law, (the SEC’s Reg FD rules) a public company cannot selectively provide additional disclosure materials to a PE firm or any other current or potential investor. The only channel a company can use is the SEC filing system. This is the salient fact, and irresolvable dilemma at the heart of these PtP deals. The PE firms know only what the SEC documents tell them, and anybody else with internet access.

The PE firms can, and often do, pay lawyers to hunt around, send junior staff to count the number of eggs on supermarket shelves, use an expert network, or bring in McKinsey, or other consultants, to produce some market research of highly dubious value. There are no reliable public statistics, and no way to obtain them, about any industry, market or product in China. Market research in China is generally a well-paid form of educated guesswork.

So, PE firms enter PtP deals based on no special access to company information and no reliable comprehensive data about the company’s market, market share, competitors, cash collection methods in China. Throw in the fact these same companies have been seriously hammered by the US public markets, that some stand accused of fraud and deception, and the compelling logic behind PtP deals begins to look rather less so.

Keep in mind too the hundreds of millions being wagered by PE firms all goes to buy out existing shareholders. None of it goes to the actual company, to help fix whatever’s so manifestly broken. The same boss is in charge, the same business model in place that caused US investors to value the company like broken-down junk. In cases where borrowed money is used, the PE firm has the chance to make a higher rate of return. But, of course, the Chinese company’s balance sheet and net income will be made weaker by the loans and debt service. Chances are there are lawsuits flying around as well. Fighting those will drain money away from the company, and further defocus the people running things. Put simply the strategy seems to be try to fix a problem by first making it worse.

There’s not a single example I know of any PE firm making money doing these Chinese “take privates” in the US and yet so many are running around trying to do them. If nothing else, this proves again the old saying it’s easy to be bold with someone else’s money.

OK, we’re all grown-ups here. I do understand the meaning of a “nudge and a wink”, which is what I often get when I ask PE firms how they get around this information deficiency. The suggestion seems to be they possess, directly from the company owner, some valuable insider information — maybe about the name of a potential buyer down the road, or a new big contract, or the fact there’s lot of undisclosed cash coming into the company. Remember, the PE firms have extensive discussions with the owner before going public with the “take private” bids. The owners always need to commit upfront to backing the PE take private deal, to keep, rather than tender,  their shares and so become, with the PE firm, the 100% owner of the business after the PtP deal closes.

These discussions between the PE firm a Chinese company boss should legally be very narrowly focused, and not include any material information about the business not disclosed to all public shareholders. These discussions happen in China, in Chinese. Is it possible that the discussions are, shall we say, more wide-ranging? Could be. The PE firm thus may have an informational advantage they believe will help them make money. The problem is they’ve gotten it from a guy whose probably committed a felony under US law in supplying it. The PE firm, meantime, is potentially now engaged in insider trading by acting on it. Another felony.

All this risk, all this headache and contingent liability, so a private equity firm can put tens, sometimes hundreds of millions of third party money at risk in a company that the US stock market has concluded is a dog. Taking private or taking leave of one’s senses?

 

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China’s GPs search for exits — Private Equity International Magazine

Leave a Comment / May 24, 2013

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Chinese GPs are running low on exit options, but the barriers to unconventional routes – like secondary sales to other GPs – remain high.

By Michelle Phillips

China’s exit woes are no secret. With accounting scandals freezing the IPO route both abroad and domestically, the waiting list for IPO approval on China’s stock exchanges has come close to 900 companies.  Fund managers have at least 7,550 unexited investments worth a combined $100 billion, according to a recent study by China First Capital. However, including undisclosed deals, the number of companies could be as high as 10,000, says CFC’s founder and chairman Peter Fuhrman.
CITIC Capital chief executive Yichen Zhang told the Hong Kong Venture Capital Association Asia Private Equity Forum in January that because many GPs promised high returns in an unrealistic timeframe (usually three to five years), LPs were already starting to get impatient. He also predicted that around 80 percent of China’s smaller GPs would collapse in the coming years. “The worst is yet to come,” he said.
What ought to become an attractive option for these funds, according to the CFC study, are secondary buyouts. Even if it lowers the exit multiple, secondaries would provide liquidity for LPs, as well as potentially giving the companies an influx of cash, Fuhrman says.

More

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Private Equity Secondaries in China: Hold Periods, Exits and Profit Projections

Leave a Comment / April 11, 2013

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How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital’s latest research note. An abridged version is available by clicking here. Titled, “Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity” the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital’s path-breaking research  to measure the scale of the problem of unexited PE investments in China,  and to illuminate strategic alternatives for GPs investing in China.  China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, “these [hold period and investment return] models tend to support the thesis that “Quality Direct Secondaries“  currently offer the best risk-adjusted opportunities in China’s PE asset class.”  Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China’s still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

  1. IPO
  2. Trade sale / M&A
  3. Secondary sale
  4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. “Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals.”

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only,  option available for a PE firm with diminishing fund life. “Buyers of these direct secondaries will not avoid or outrun exit risk,” the report advises. “It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund’s hold period. ”

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China “Quality Secondaries” offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure,  are not available in the abridged version.

 

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The Ambow Massacre — Baring Private Equity Fails in Its Take Private Plan

1 Comment / April 4, 2013

 

In the last two years, more than 40 US-listed Chinese companies have announced plans to delist in “take private” deals.  About half the deals have a PE firm at the center of things, providing some of the capital and most of the intellectual and strategic firepower. The PE firms argue that the US stock market has badly misunderstood, and so deeply undervalued these Chinese companies. The PE firms confidently boast they are buying into great businesses at fire sale prices.

The PE firm teams up with the company’s owner to buy out public shareholders, with the plan being at some future point to either sell the business or relist it outside the US. At the moment, PE firms are involved in take private deals worth about $5 billion. Some of the bigger names include Focus Media, 7 Days Inn, Simcere Pharmaceutical.

The ranks of “take private” deals fell by one yesterday. PE firm Baring Private Equity announced it is dropping its plan to take private a Chinese company called Ambow Education Holding listed on the New York Stock Exchange. Baring, which is among the larger Asia-headquartered private equity firms, with over $5 billion under management,  first announced its intention to take Ambow private on March 15. Within eleven days, Baring was forced to scrap the whole plan. Here’s how Baring put it in the official letter it sent to Ambow and disclosed on the SEC website, “In the ten days since we submitted the Proposal, three of the four independent Directors and the Company’s auditors have resigned, and the Company’s ADSs have been suspended from trading on the NYSE. As a result of these unexpected events, we have concluded that it is not possible for us to proceed with the Transaction as set forth in our Proposal.”

Baring’s original proposal offered Ambow shareholders $1.46 a share, a 45% premium over the price at the time. Baring is already a shareholder of Ambow, holding about 10% of the equity. It bought the shares earlier this year.  Assuming the shares do start trading again, Baring is likely sitting on a paper loss of around $8mn on the Ambow shares it owns, as well as a fair bit of egg on its face. Uncounted is the amount in legal fees, to say nothing of Baring’s own time, that was squandered on this deal. My guess is, this is hardly what Baring’s LPs would want their money being spent on.

Perhaps the only consolation for Baring is that this mess exploded before it completed the planned takeover of the company. But, still, my question, “what did Baring know about any big problems inside Ambow when it tabled its offer ten days ago?” If the answer is “nothing”, well what does that say about the quality of the PE firm’s due diligence and deal-making prowess? How can you go public with an offer that values Ambow at $105 million and only eleven days later have to abandon the bid because of chaos, and perhaps fraud, inside the target company?

It is so easy, so attractive,  to think you can do deals based largely on work you can do on a Bloomberg terminal. Just four steps are all that’s needed. Download the stock chart? Check. Read the latest SEC filings, including financial statements? Check. Discover a share trading at a fraction of book value? Check. Contact the company owner and say you want to become his partner and buy out all his foolish and know-nothing US shareholders? Check. All set. You can now launch your bid.

Here the stock chart for Ambow since it went public on the NYSE:

 

 

So, in a little more than two years, Ambow’s market cap has fallen by 92%, from a high of over $1 billion, to the current level of less than $90mn. That’s not a lot higher than the company’s announced 2011 EBITDA of $54mn, and about equal to the total cash Ambow claimed, in its most recent annual report filed with the SEC, it had in the bank. Now really, who wouldn’t want to buy a company trading at 1.5X trailing EBITDA and 1X cash?

Well, start with the fact that it now looks like those numbers might not be everything they purport to be. That would be the logical inference from the fact that the company’s auditors and three of its board members all resigned en masse.

That gets to the heart of the real problem with these “PtP” (public to private) deals involving US-listed Chinese companies. The PE firms seem to operate on the assumption that the numbers reported to the SEC are genuine, and therefore that these companies’ shares are all trading at huge discounts to their intrinsic worth. Well, maybe not. Also, maybe US shareholders are not quite as dumb as some of the deal-makers here would like to believe. From the little we know about the situation in Ambow, it looks like, if anything, the US capital market was actually being too generous towards the company, even as it marked down the share price by over 90%.

A share price represents the considered assessment of millions of people, in real time. Some of those people (suppliers, competitors, friends of the auditor) will always know more than you about what the real situation is inside a company. Yes, sometimes share prices can overshoot and render too harsh a judgment on a company’s value. But, that’s assuming the numbers reported to the SEC are all kosher.  If we’ve learned anything in these last two years it’s that assuming a Chinese company’s SEC financial statement is free of fraud and gross inaccuracy is, at best, a gamble. There simply is no way a PE firm can get complete comfort, before committing to taking over one of these Chinese businesses listed in the US, that there are no serious dangers lurking within. Reputation risk, litigation risk, exit risk — these too are very prominent in all PtP deals.

Some of the other announced PtP deals are using borrowed money, along with some cash from PE firms, to pay off existing shareholders. In such cases, the risk for the PE fund is obviously lower. If the Chinese company genuinely has the free cash to service the debt, well, then once the debt is paid off, the PE firm will end up owning a big chunk of a company without having tied up a lot of cash.  Do the banks in these cases really know the situation inside these often-opaque Chinese companies? Is the cash flow on the P&L the same cash flow that passes through its hands each month?

There’s much else that strikes me as questionable about the logic of doing these PtP, or delist-relist deals. For one thing, it seems increasingly unlikely that these businesses will be able to relist, anytime in the next three to five years, in Hong Kong or China. I’ve yet to hear a credible plan from the PE firms I’ve talked to about how they intend to achieve ultimate exit. But, mainly, my concerns have been about the rigor and care that goes into the crafting of these deals. Those concerns seem warranted in my opinion, based on this 11-day debacle with Baring and Ambow.

Some of the Chinese-listed companies fell out of favor for the good reason that they are dubious businesses, run with shoddy and opaque practices, by bosses who’ve shown scant regard for the letter and spirit of the securities laws of the US. Are these really the kind of people PE funds should consider going into business with?–

 

Correction: I see now Barings actually has owned some Ambow shares for longer, and so is likely sitting on far larger losses on this position. This raises still more starkly the issue of how it could have put so much of its LPs money at risk on a deal like this, upfront, and without having sufficient transparency into the true situation at the company. This looks more like stock speculation gone terribly wrong, not private equity.

Addition: Three other large, famous institutional investors also all piled into Ambow in the months before Baring made its bid. Fidelity, GIC and Capital Group reported owning 8.76%, 5.2% and 7.4% respectively, or a total of 21.3% of the equity. They might have made a quick buck had the Baring buyout gone forward. Now, they may end up stranded, sitting on large positions in a distressed stock with no real liquidity and perhaps nowhere to go but down.

 

 

Direct Secondary Investment Opportunities in China Private Equity

Leave a Comment / February 26, 2013

 

As detailed follow-up to our report on the current challenging crisis of unexited PE investments in China, China First Capital has prepared a new research note. You can download the abridged version by clicking here.

This note provides far more detailed data and analysis on the unexited PE deals: by industry, original deal size, currency, round, and most importantly, “tier of PE”. This should give a more concrete understanding of the current opportunity in direct secondaries in China, as well as numerical challenges all GPs active in China will face exiting.

China First Capital is currently the only firm with this data and analysis. In addition to this note, we will also share in coming weeks three others research notes:

1. Secondary deals modeled on prospective IRR and hold periods
2. Risk-scoring metrics for primary and secondary deals in China
3. Portfolio analytics specific to primary and secondary investments in China

Beyond this work, shared as a service to our industry, to help facilitate the development of an efficient and liquid exit channel of direct secondaries in China, everything else will remain our confidential work product to be deployed only for clients that retain us. An introduction to our secondaries services is available by clicking here.

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China Securities News: 中国首创投资董事长：二级市场并购有望发力

Leave a Comment / February 22, 2013

 

If your Chinese is up to it –  or perhaps if you want to see how well-designed the best Chinese newspapers are — click here to see the story today in China Securities News (中国证券报) that includes both an interview with me and excerpts from our Chinese-language report on the crisis in Chinese private equity.

Unlike the sorry situation in the US and elsewhere, newspapers in China are still thriving. The leading papers, including China Securities News, have large nationwide readership and distribution, with the large profits to match. And no, the contents are not fiercely censored. If they were, no one would buy them.

I’m quite chuffed this paper devotes so much space to our report and its conclusions. It’s an affirmation of what a great job my China First Capital colleagues did in preparing the Chinese version. My own modest hope is that this article, together with several others that have appeared recently in other mainstream Chinese business publications, will help catalyze a more active discussion of the current crisis in the PE industry in China. There is, as my interview emphasizes, a lot at stake for China.

The sudden stop of both IPOs and new private equity investment in China means that private companies are being denied access to much-needed capital to finance growth. This is already beginning to have serious impact on China’s private sector and the economy as a whole. I foresee no significant change coming anytime soon. For private entrepreneurs, these are dark days indeed. Keep in mind, China’s private sector now accounts for over half of gdp — and it’s the “half” that provides most of new jobs as well as just about every product and service ordinary Chinese enjoy spending money on.

As a lot of non-Chinese speakers have heard, the Chinese words “crisis” and “opportunity” share a common root (危机，机会）. There is much wisdom in this. The current crisis in China PE is also perhaps the best opportunity ever for stronger PEs to find and close great investments, through purchases of what we call “Quality Secondaries”.

Investment opportunities don’t get much riper than this one.

 

Chinese Market Loses Its Bite — Private Equity News Magazine

Leave a Comment / December 6, 2014

–PEnews

 

Download complete text

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A stagnant exit market is likely to cause problems for firms that ventured into China in the boom years

Statistics rarely tell the whole story. However, as China celebrates the Year of the Snake, the most recent figures for private equity exits in the country make sobering reading for those who were convinced that the surge in private equity in the world’s most populated nation was the ticket to easy returns. In the final quarter of 2012, there was no capital raised by sponsors through primary initial public offerings of companies they backed, no capital raised through sales to strategic buyers and just $30 million from secondary buyouts, according to data from Dealogic.
That collapse in the exit market is creating a huge backlog of businesses in private equity hands that could force many companies to the wall and drive a shakeout in the industry, losing investors billions in the process. Global private equity firms, from large buyout specialists TPG Capital and Carlyle Group to mid-market players like 3i Group, all flooded
into the Chinese market raising capital from international investors for deals on the expectation of outsized returns as the economy opened and boomed. They were joined by thousands of domestic players that raised capital in local currency from the growing band of China’s wealthy individuals eager to get a slice of the market.

Incredible Success

Peter Fuhrman, chairman and CEO of investment bank China First Capital, said: “In the course of the last five years China has grown into the largest market by far for the raising and deploying of growth capital in the world. It has been an incredible success story when it comes to talking investors into opening up their wallets and allocating much-needed capital to thousands of outstanding Chinese entrepreneurs.” More…

 

 

Stagnant IPO Market Strangles Chinese Private Equity Exits — Financier Magazine

Leave a Comment / December 5, 2014

Fin

From humble beginnings in 2000, the past decade has seen the Chinese private equity (PE) market blossom into a global powerhouse. However, according to a new report released by investment bank China First Capital (China First), the Chinese market is in the formative stages of a crisis which could undermine all of the extraordinary strides it has made in recent years.

The report, ‘Secondaries: A necessary and attractive exit for PE deals in China’, notes that while there have been nearly 10,000 deals worth a combined $230bn completed within the Chinese market between 2001 and 2012, around 7500 of those deals remain ‘unexited’. This has left approximately $130bn of PE and venture capital investment locked inside Chinese companies with very few exit options available. More…

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Paid to Gamble But Reluctant To Do So

Leave a Comment / January 24, 2013

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Venture Capital Financing in the US

(Source; The Wall Street Journal)

 

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They are the best-paid gamblers in the world, the General Partners at private equity and venture capital firms. They are paid to take risks, to make bets, with other people’s money. And for this, they usually get a guaranteed high annual retainer, a salary that generally puts them in the top 1% of all wage-earners in their country, and also a share of profits earned from putting others’ money at risk. In other words, their life is on the order of “heads I win, tails I win” compensation. They make a handsome salary, have all their expenses covered, are unlikely ever to get fired, and also usually get to claim 20%-25% of the profits from successful deals.

Given those incentives, and the fact the guys with the money (your fund’s LPs) are paying you to find great opportunities and bet on them rather than sit on your hands, you would assume that GPs would want to keep the flow of new deals moving along at a reasonable pace. In fact, inactivity is, next to losing all the LPs money on bad investments, the surest way for a PE fund to put itself out of business. And yet this do-nothing strategy is now common across China’s private equity industry. For the better part of a year, deal-making has all but dried up.

From a recent high of around 1,200 PE deals closed in a single year in China,  in 2012 the total tumbled. My surmise is that the number of new PE deals closed in China last year was down at least 75% from 2011. The activity that took place did so almost entirely during the first half of the year. An industry now holding over $100 billion in capital and employing well over 10,000 people, including some of the most well-educated and well-paid in China, ground to a halt during 2012.

Let me offer up one example. I won’t name them, since I know and like the people running this shop: a fund that is among the biggest of all China-focused PEs, with over $4 billion in capital, made a total of three investments in all of 2012. Two of them were in “club deals” where they threw money into a pot along with a bunch of other funds. Though they keep a full-time staff of 100, funded by the management fee drawn from LPs money, this firm closed only one deal that they actually initiated. At a guess, these guys have an annual management fee in excess of $50mn, and during 2012, their headcount more than doubled.

In any other line of work, a company that decreased its output to about zero, while significantly increasing its expenses, would be on the fast-track to insolvency. But, not in the PE industry in China. It’s currently the norm. Now, of course, those same PE firms will say they are keeping themselves busy monitoring their previous investments, rather than closing new ones. Yes, that’s necessary work. But, still, the radical slow-down in PE activity in PE is without precedent elsewhere in the PE and VC world.

Look, for example, to the VC industry in the US. In good years and bad, with IPOs plentiful and nonexistent, VC firms keep up their dealmaking.  These two charts at the top of the page show this quite clearly. Across a six-year cycle of capital markets boom and bust, the number of new VC investments closed stayed relatively constant at between 600-800 per quarter. In other words, VC workloads in the US stayed relatively stable. They kept channeling LP money into new opportunities. The dollar amounts fluctuated, peaking recently during the run-up to the highly-anticipated IPOs of Linkedin, Facebook, Groupon and Zynga.  Valuations rose and so did check size. But, deal flow stayed steady, even after Linkedin, Facebook, Groupon and Zynga’s share prices nosedived following IPOs.

This is the picture of a mature industry, managed by experienced professionals who’ve seen their share of stock market up and down cycles, heard thousands of pitches for “sure things” that raised some money only to later crash and burn. Some VC firms crashed and burned with them. But, overall, the industry has kept its wits, its focus and its discipline to invest through bad times as well as stellar ones.

The contrast with China’s PE industry is rather stark. There are perhaps as many as 5,000 PE and VC firms in China. No one knows for sure. New ones keep getting formed every week. The more seasoned of the China PE and VC firms have a history of about 10 years. But, the overwhelming majority have been in this game for less than five years. In other words, today there is a large industry, well-financed and with control over a significant amount of the growth capital available in the world’s second largest economy, that was basically created out of nothing, over just the last few years.

Obviously, these thousands of new PE firms couldn’t point to their long history of identifying and investing in private companies. But, LPs poured money in all the same. They were investing more in China — in the remarkable talents of its entrepreneurs and the continued dynamism of its economy — than in the track record of those doing the investing. That seems a wise idea to me. As I’ve mentioned more than once, putting money into China’s better entrepreneur-led companies is certainly among the better risk-adjusted investment opportunities in the world.

If anything, the opportunities are riper and cheaper than a year ago, as valuations have come down and good companies with significant scale (revenues above $25mn) have kept up a rate of profit growth above 30%. In the US VC industry, this would be a strong buy signal. Not so in China. Not now.

PE firms are collecting tens of millions of dollars from LPs in management fees, but not putting much new LP money to productive use by investing in companies that can generate a return. Nor are they actively exiting from previously-made investments and returning capital to LPs. This situation can’t last indefinitely.  For people handed chips and paid to gamble, it’s unwise to spend too much of the time away from the casino snoozing in your high roller suite.

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China Private Equity Secondaries — New York Times, Bloomberg, CNNMoney

Leave a Comment / March 12, 2014

–Dual

It is imperative for the private equity industry in China to develop an efficient, liquid market for secondaries. Our goal is both to facilitate an active dialogue, as well as help bring this about. Only by breaking the current logjam of no exits in China PE can money again start to flow in significant amounts to capital-hungry private companies. No less than the future fitness of China’s entrepreneurial private sector is at stake.

In the last several days, along with the Wall Street Journal article posted yesterday, five other financial media (New York Times, Bloomberg, AVCJ, PEI, CNN Money) published stories on this topic, referencing research results from China First Capital. I’m pleased to share them.

Private Equity in China: Which Way Out?

HONG KONG — Welcome to the private equity game in China: you can buy in anytime you like, but you can never leave. At least, that is how it is starting to seem for many of the firms that bought in big during the boom of last decade.

Starting from a base of almost nothing in 2000, global private equity funds and their start-up local counterparts rushed into the Chinese market – completing nearly 10,000 deals worth a combined $230 billion from 2001 to 2012, according to a report released this week by China First Capital, a boutique investment bank based in the southern city of Shenzhen.More…

 

Private-equity funds in China are still holding 82 percent of the companies they’ve invested in since 2007, as the frozen market for initial public offerings keeps them from exiting, a study showed.

Funds hold 6,584 companies after disposing of 1,445 and seeing 20 go bankrupt, according to a report from China First Capital, a Shenzhen-based firm that advises on private equity and mergers. Investors still hold companies valued at $94.3 billion, compared with a total of $194.7 billion, according to public data compiled by the firm and its own research. More...

 

 

At least 200 private equity portfolio companies in China are attractive targets for potential secondary buyers and the number is likely to grow 15-25% per year as funds come to the end of their lives and find that exit options are still limited.

These companies represent the cream of a much larger pool of investments that are as yet un-exited by Chinese PE investors, according to a proprietary study by specialist investment bank China First Capital. It estimates that more than 7,500 portfolio companies remain in private equity firms’ portfolios from investments made since 2000.  More…

 

As other exit avenues for private equity dry up in China, GP-to-GP secondaries could be the only option for the 7,500 unexited portfolio
companies, according to a recent study from China First Capital.

China has 7,550 unexited private equity investments totaling $100 billion that will soon have to be realised through routes other than the traditional IPO, according to a recent study from China First Capital.
As fund lives begin to expire, Peter Fuhrman, chairman and chief executive of CFC, believes the standout option will be GP-to-GP secondary transactions. This is especially true for RMB funds, which have a three-to-five year life rather than the ten years typical with US dollar funds. More…

China’s stalled market for new share listings is severely limiting the ability of private equity funds to cash out their
investments in the country, according to a new research report from China First Capital.
The Shenzhen-based investment bank analyzed more than 9,000 private equity and venture capital deals completed in
China since 2001, and found that more than $100 billion — much from the U.S. — remains invested. More…

 

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Two New CFC Research Reports

Leave a Comment / April 7, 2013

China First Capital (中国首创）published two new research reports, one in English and one Chinese. Both are now available for download here. The contents are different, as is the focus.

To download the English report, titled “Private Equity in China 2012: The Pace of Change Quickens“, Click here

For the Chinese report, “2012-2013 中国私募股权融资与市场趋势” Click here

In fact, “No Exit” would be the more appropriate title for a report about private equity in China this year. Jean-Paul Sartre‘s famous play of that name is a conversation between three dead people stuck in hell. They are eternally damned. PE funds currently stuck inside Chinese investments with no way to exit are not in such a hopelessly miserable situation. But, some may be feeling that way.

Over the course of the last twelve months, first the US stock market, then Hong Kong’s, and finally China’s own domestic bourse all pretty much slammed the door shut on IPOs for Chinese companies. In previous years, over 300 Chinese companies would IPO. This year, that number will fall by at least 80%, maybe more. Stock markets in the US, Hong Kong and China all have slightly different explanations for the sharp drop-off in IPOs of Chinese companies. But, a common thread runs throughout: a deep distrust among investors and regulators of the accuracy of Chinese companies’ financial accounts.  The view is that a Chinese company’s IPO prospectus may be as much a work of fiction as the Sartre play. Under such circumstances, companies can’t IPO, and PE firms can’t find buyers for their illiquid shares.

China’s domestic stock markets were the last to bar the door against Chinese IPOs. Until mid-year, China’s all-powerful securities regulator the CSRC was continuing to process and approve IPO applications, and companies were going public at a rate of about five a week. Then, in July, the whole complex system of approving and placing IPO shares basically stopped functioning. A Chinese company called Xindadi (新大地） exposed a serious defect at the heart of the regulatory system in China. The CSRC’s primarily function is to stop any bad company with dodgy accounts from accessing China’s domestic capital markets. Layer upon bureaucratic layer is piled up inside the CSRC to prevent officials from conspiring together to let a bad company’s application pass through. The underwriter, the lawyers and accountants are also held legally accountable to detect and expose bad companies. Yet Xindadi managed to slip through.

Xindadi’s IPO application was approved by the CSRC and the company was waiting its turn to go public when media reports surfaced that described a rather clumsy, though, nearly-successful fraud. Xindadi’s financial accounts  turned out to be fake from top to bottom. Xindadi’s business model is aptly summarized by comments made nearly a century ago by the US Federal Trade Commission about another rogue outfit, ” fraud, deceit, misrepresentation, dishonesty, breach of trust and oppression.”

The Xindadi IPO was pulled before the underwriters could sell any shares. The CSRC went into a kind of post-traumatic shock from which it’s yet to recover. It basically stopped approving new IPOs in most cases. Meanwhile the number of Chinese companies who’ve filed for IPO continues to lengthen, and now is over 800. If and when the CSRC goes back to its previous rate of approving IPOs, which isn’t likely anytime soon,  it would take four years to clear this backlog.

Predictably, for PE firms in China,  “No Exit” has now turned into “No Entrance”. Not knowing when IPO windows will reopen, PE firms have mainly stopped doing new deals.  Chinese private sector companies, for whom PE is the main source of growth capital, are feeling the pinch. Equity capital, even for good companies,  is difficult, if not impossible, to come by. The abrupt cut-off of PE financing will certainly lead to slower growth and fewer new jobs in China.

IPOs of Chinese companies in the US, Hong Kong and China have been an important, if little recognized, part of China’s growth story over the last decade. They fueled the boom in private equity  — both the creation over the last five years of hundreds of new PE firms and the raising of tens of billions of dollars in new capital –  and with it, a huge increase in total net new investment into China’s private sector companies. Chinese investment, particularly spending by state-owned companies, and government-backed infrastructure projects, is still largely financed by bank lending. But, the equity capital provided by PE firms has played a key part in financing the growth of larger private companies in China.  PE money has underpinned increased competition, choice and economic dynamism in China.

Now that gusher of PE money has turned to a trickle.  What next for private equity and corporate finance in China? The two new CFC reports summarize some of the main developments and trends in private equity and capital markets this year, and makes some predictions about the year to come. The Chinese-language report was written, as are other CFC Chinese reports, for the specific use and reference of domestic Chinese business-owners and senior management. The key message is that it’s getting far more difficult for companies to raise money, either through private placement or IPO.

The English report focuses more heavily on what’s going on in the private equity industry in China. Unlike many, I remain overall extremely positive about the fundamentals in China, that PE investment in China’s growing private sector companies represents the best risk-adjusted investment opportunity in the world. While exits through IPO are far fewer, China’s strongest investment asset remains firmly in place:  the compounded genius of its millions of private entrepreneurs to create wealth and push forward positive social and economic change.

 

Jiuding Capital: Local Boy Makes Good Atop China’s PE Industry

1 Comment / June 17, 2013

In China’s PE jungle, a mouse is king. Started just five years ago, Kunwu Jiuding Capital (昆吾九鼎投资管理有限公) has probably achieved the best results and best returns for investors in China’s private equity industry over the last three years. Indeed, few if any PE investors anywhere have out-performed Jiuding in recent years. (For a more recent analysis on challenges facing Jiuding, please click here. )

With only around $1 billion in assets, Jiuding is around 1%-2% the size of the leading global PE firms like Blackstone, KKR, Bain Capital and Carlyle. Yet, none of these firms matches Jiuding’s recent record at investing, exiting, and pocketing big returns in China. The firm is about as different from the likes of TPG, KKR and Carlyle as firms in the same industry can get. Jiuding isn’t staffed with Ivy League MBAs, operates out of modest offices, makes no claim to particular expertise in business operations, nor does it reward its partners with hundreds of millions in profits from carried interest.

Jiuding has mastered a form of PE investing devoid of glamour, prestige or deal-making genius. Rather than “Barbarians at the Gate“, think more “Accountants at the Cash Till“. Jiuding may want to savor its current status as “king of the China PE jungle”. The money-making formula Jiuding has used so effectively is getting tougher all the time.

The Jiuding investment method is blunt: it invests only in Chinese companies it believes will very soon thereafter get approved for domestic IPO. It’s not trying to guess which industries will flourish, or how Chinese consumers will spend their money in the future. It makes no bets on unproved technologies, or companies that may be growing fast, but are still years away from an IPO. Its investment technique is based on reproducing internally, as much as possible, the lengthy, opaque approval IPO process of China’s all-powerful securities regulator the CSRC.

Jiuding focuses more on guessing what the CSRC will do, rather than how a particular company will fare. This way, it hopes to capture a big valuation differential between its entry price and exit price after IPO. At its high point two years ago, there was a ten-fold gap between Jiuding’s entry and exit multiples. Jiuding bought in at a p/e of less than 10X, and could exit at over 80X. Though share prices and p/e multiples have fallen, the gap remains ample, still under 10X going in, and a likely 25X-30X going out.

Here’s the way it works: the CSRC IPO approval process can take anywhere from two to five years. Jiuding times its investment as close as legally permissible to the time when the company will file for IPO. It then gets to work doing everything it can to improve the likelihood of CSRC approval, attending meetings at the CSRC, lobbying backstage. When things go smoothly, Jiuding can enter and exit an investment in three years, including the mandatory one-year lockup after IPO.

The average hold time for other PE firms investing in China can be as long as six to eight years. These other firms are willing to invest earlier and then help the company transition, often over a two to three year period, to full tax and regulatory compliance. This is a prerequisite before filing for IPO. Change in China is perpetual, sudden, frenetic. The longer a PE firm holds an investment, the greater the risk some change in the rules, or the domestic market, or the exchange rate, or the competitive landscape will ruin a once-strong company.

These uncertainties, as well as the significant risk a Chinese company will not pass CSRC’s IPO approval process, are the two largest China PE investment risks that Jiuding tries to eliminate. For Jiuding, this means a hyper-technical focus on whether a company is paying all its taxes and whether its main customer is actually the founder’s brother-in-law. In other words, are there serious related party transactions? This is often the main reason the CSRC turns down an IPO application.

Other PEs, particularly the global giants,  take a different approach. They expend huge energy on the process of analyzing and predicting the future course of a company’s products, markets, competitive position. This involves a lot of brain power and also some guesswork. The results are mixed. A lot of deals never close, because the PE firm, after spending hundreds of thousands of dollars and lots of man-hours, can’t complete due diligence. Others will never reach the stage of even applying for IPO, let alone getting approval.

Jiuding seems perfectly-adapted to the Chinese investment terrain. When its process works, its bets pay off handsomely, often delivering returns of at least three times capital invested. Jiuding calls this a “PE factory method”. It tries to systematize as much of the investment process as possible. Jiuding has a huge staff of at least 250 people, ten times the size of other PEs in China. They are kept busy doing this work of collecting company data and then simulating the CSRC’s approval process. It invites its LPs, mainly wealthy Chinese bosses, to participate in deal screening and approval. If the majority of LPs doesn’t approve of a deal, it doesn’t get done. In the PE industry, this is often known as “letting the lunatics run the asylum”.

To be sure, Jiuding doesn’t always get it right. It does more deals each year than just about every other PE firm in China. Quite a few will flame out before IPO. But, Jiuding will usually get its original investment back, by forcing companies to buy back the shares. Meantime, its IPO hit rate is high, as far as I can tell. The company discloses information only sporadically, and its website lists only fourteen IPOs. Its actual tally is certainly far higher. Jiuding regards everything about its business — its portfolio of investments, its total capital, its staff size — as commercial secrets.

Jiuding differs in another important way from larger, better-known PE firms: it helps itself to less of its LPs’ money . Jiuding takes a lower management fee, usually a one-time 3% charge, rather than annual 1%-3%, and awards itself with a smaller carry on successful deals. Jiuding’s almost as efficient at raising money as it is investing it. It’s already raised at least ten different funds, including, recently, a dollar one.

With everything going so well, Jiuding, and its stripped-down approach to PE investing, looks unstoppable. But, there are some signs of serious problems ahead for Jiuding. Its main problems now aren’t raising money or even finding good companies. Partly, it’s a challenge familiar to most successful Chinese companies, including many Jiuding has invested in: copycats start springing up everywhere. In the last two years, hundreds of new Renminbi PE firms were founded. Many are trying to duplicate Jiuding’s formula. They also focus on companies ready to apply for IPO, and also try to anticipate the way the CSRC will rule on the application. Jiuding needs to fight harder now to win deals, and often does this by agreeing to invest at higher price than others. That will inevitably lower potential returns.

The second, larger problem is the CSRC’s IPO approval process itself. It is becoming slower, and also even more impenetrable and unpredictable, even to the savants at Jiuding. It’s harder now for Jiuding to get in and out of deals quickly, a key to its success. The backlog of Chinese companies with CSRC approval and waiting to IPO is now at around 500. In most cases, that means a wait of at least two years after the laborious CSRC process is complete. A lot can go wrong during that time. So, an investor like Jiuding will need to understand, before going in, more about a company and its longer-term prospects.

In China’s PE market, where good companies are plentiful and IPO exits are limited, Jiuding has prospered by focusing more on understanding the regulator than on understanding a company’s business model and industry. It never needed to bother much with monitoring the day-to-day dramas of running a company, or offering sage advice as a board member, or helping a company expand its partnerships and improve marketing. Yet, all this is becoming more and more necessary. These aren’t skills Jiuding has mastered. Who has? The same big global PE firms (including Carlyle, TPG, Blackstone, KKR, Bain Capital) that Jiuding has lately run circles around. Jiuding’s “PE factory” must adapt or die.

 

 

Dollars No Longer Welcome

1 Comment / October 23, 2012

2012 is going to be a bad year for new dollar investment in Chinese financial assets. This reverses what was thought to be, only a few years ago, an irreversible trend as more of the world’s largest and most sophisticated investors sought to increase the asset allocation in China. It’s not that China has fallen out of favor with institutional investors. If anything, China’s comparative strengths — in terms of solid +7% economic growth, a vibrant domestic consumer market, reasonably healthy banks, prudent fiscal policy — stand in ever starker contrast with the insipid economies and improvident governments of Europe, the US, Japan.

So, how come fewer dollars are flowing into China? The main reason is that the stock markets in the US and Hong Kong have fallen out of love with Chinese IPOs. These two stock markets have been the primary source for more than a decade of new dollar funding for domestic Chinese companies. Just two years ago, Chinese companies accounted for one-third of all IPOs in the US. The IPO market for Chinese companies listing in Hong Kong was even hotter. Last year, almost $70 billion was raised by Chinese companies listing on the Hong Kong Stock Exchange.

Dollars raised in New York or Hong Kong IPOs were converted into Renminbi, then invested to fuel the growth of hundreds of Chinese private companies and SOEs. Stock markets in London, Frankfurt, Seoul, Singapore, Sydney also provided access for Chinese companies to list and raise capital there. Overall, the international capital markets have been a key source of growth capital for Chinese companies, and so an important part of China’s overall economic transformation.

This year, the US will probably host fewer than five Chinese IPOs, and the total amount raised by Chinese companies in Hong Kong will be down by at least 65% from last year. The two other sources of dollar investment in Chinese companies — private equity and institutional purchases of Chinese shares — are also trending downward. Of the two, PE money was by far the more important, particularly over the last decade. In a good year, over $5 billion of capital was invested into private Chinese companies by PE firms. But, rule changes in China began to make dollar PE investing more difficult starting five years ago. It’s harder now to get permission to convert dollars into Renminbi, and Chinese companies can no longer easily create offshore holding company structures to facilitate dollar investment and an eventual exit through offshore IPO.

Rule changes slowed, but didn’t stop, dollar PE investing in China. The bigger problem now is that stock market investors in the US, and to a slightly lesser extent those in Hong Kong, no longer want to buy Chinese shares at IPO. It’s mainly because retail and institutional investors outside China distrust the quality and truthfulness of Chinese corporate accounting. If offshore IPOs dry up, dollar PE investors have no way to cash out. M&A exit is still rare. The twin result this year: less dollar PE money entering China, and also a steep drop in offshore IPO fundraising for Chinese companies.

Consider what this means: the world’s largest pools of institutional capital are finding it more difficult to invest in the world’s fastest growing major economy. This makes no financial sense. Chinese companies have a huge appetite for growth capital, and have the potential to achieve high rates of return for investors. Investment in China’s private entrepreneurial companies remains perhaps the best risk-adjusted investment class in the world. But, all the same, this year will see a steep drop of new international investment in Chinese companies.

Perhaps partially to compensate, China this year has liberalized the rules somewhat to allow international institutions to buy shares quoted in China. But, since that money goes to buy shares held by other investors, rather than to the company itself, investing in Chinese-quoted shares has little, if any impact, in filling Chinese companies’ need for growth capital. The appeal of owning China-quoted shares is hardly overpowering, as the market has been a poor performer overall, and share prices are more propelled by rumor than fundamental value.

At any earlier time in recent history, a dramatic drop like this year’s in new dollar investment into China would be felt acutely by Chinese companies. But, as dollar investing has dried up, Renminbi investing has more than filled the gap. The Shenzhen and Shanghai stock markets are now far larger sources of fresh IPO capital for Chinese companies than New York or Hong Kong ever were. Also, Renminbi PE firms have proliferated.

For a mix of reasons, China is now, arguably, more financially self-reliant than it has been since Mao’s day. Autarky used to be state policy. Now, it is a consequence of China’s own rising affluence and capital accumulation, together with some nationalistic policy changes and the fall-off in interest among international investors to finance Chinese IPOs. Ironically, as China has been drawn more into the global trade and financial system, its need for external capital has lessened.

That is unfortunate. Dollar investment in China benefits both sides. It offers dollar investors higher potential rates of return than investing in mature developed economies. This means better-funded and more generous pensions for American and European retirees. For Chinese companies, dollar investors usually tend to be more hands-on, in a good way, than Renminbi funds. So, they help improve the overall competitiveness, professionalism, corporate governance and strategic planning of the Chinese firms they invest in. Many of China’s best entrepreneurial companies — including well-known firms like Baidu, Alibaba, Tencent, as well as hundreds of domestic Chinese brand-name companies few outside of China have heard of– were nurtured towards success by dollar investors.

Since just about everyone wins from new dollar investing in China, what can be done to reverse this year’s big slide? The answer is “not a lot”. I don’t see any strong likelihood that international investors will grow less allergic to Chinese IPOs. Renminbi PE and IPO funding for Chinese companies will continue to grow strongly. Only the removal of capital controls in China, and full Renminbi convertibility, would change the current situation, and lead, most likely, to large new flows of offshore capital into China.

But, full Renminbi convertibility is nowhere in sight. For the foreseeable future, China’s growth mainly will be financed at home.