Chinext

China to fine-tune back-door listing policies for US-listed companies — South China Morning Post

 

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China reverse mergers

Mainland China’s securities regulator will fine-tune policies related to back-door listing (reverse merger)attempts by US-listed Chinese companies, industry insiders say, but it is unlikely to ban them or impose other rigid restrictions.

“It is clear that the regulator does not like the recent speculation on the A-share markets triggered by the relisting trend and will do something to curb such conduct, but it seems impossible they would shut good-quality companies out of the domestic market,” Wang Yansong, a senior investment banker based in Shenzhen, said.

The China Securities Regulatory Commission (CSRC) was considering capping valuation multiples for companies seeking relisting on the A-share market after delisting from the US market, Bloomberg reported on Tuesday. Another option being discussed was introducing a quota to limit the number of reverse mergers each year from companies formerly listed on a foreign bourse.

To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals
Wang Yansong.

However, Wang said the CSRC was more likely to strengthen verification of back-door listing deals on a case-by-case basis.

“To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals, and won’t allow poor-quality companies to seek premiums through this process,” she said.

US-listed mainland companies have been flocking to relist on the A-share market since early last year, when the domestic market started a bull run, in order to shed depressed valuations in American markets.

The valuations of relisted companies have boomed, and that has triggered a surge in speculation on possible shell companies – poorly performing firms listed on the Shanghai or Shenzhen bourses. In a process called a reverse takeover or back-door listing, a shell can buy a bigger, privately held company through a share exchange that gives the private company’s shareholders control of the merged entity.

The biggest such deal was done by digital advertising company Focus Media. Its valuation jumped more than eightfold to US$7.2 billion after it delisted from America’s Nasdaq in 2013 and relisted in Shenzhen in December last year, with private equity funds involved in the deal reaping lucrative returns.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm, said the trend of delisting and relisting was “one of the biggest wealth transfers ever from China to the US”.

“The money spent by Chinese investors to privatise Chinese companies in New York ended up lining the pockets of rich institutional investors and arbitrageurs in the US,” he said.

However, a tightening or freeze on approval of such deals would threaten not only US-listed Chinese companies in the process of buyouts and shell companies, but also the buyout capital sunk into delistings and relistings.

“The more than US$80 billion of capital spent in the ‘delist-relist’ deals is perhaps the biggest unhedged bet made in recent private equity history … if, as seems true, the route to exit via back-door listing may be bolted shut, this investment strategy could turn into one of the bigger losers of recent times,” he said.

On Friday, CSRC spokesman Zhang Xiaojun sidestepped a question about a rumoured ban on reverse takeover deals by US-listed Chinese companies in the A-share market, saying it had noticed the great price difference in the domestic and the US markets, and the speculation on shell companies, and was studying their influences.

http://www.scmp.com/business/markets/article/1943386/china-fine-tune-back-door-listing-policies-us-listed-companies

For article on a related topic published in “The Deal”, please click here

 

Leapfrogging the IPO gridlock: Chinese companies get a taste for reverse takeovers — Reuters

Reuters

Leapfrogging the IPO gridlock: Chinese companies get a taste for reverse takeovers

Outbid, outspent and outhustled: How Renminbi funds took over Chinese private equity (Part 1) — SuperReturn Commentary

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Outbid, outspent and outhustled

Renminbi-denominated private equity funds basically didn’t exist until about five years ago. Up until that point, for ten golden years, China’s PE and VC industry was the exclusive province of a hundred or so dollar-based funds: a mix of global heavyweights like Blackstone, KKR, Carlyle and Sequoia, together with pan-Asian firms based in Hong Kong and Singapore and some “China only” dollar general partners like CDH, New Horizon and CITIC Capital. These firms all raised money from much the same group of larger global limited partners (LPs), with a similar sales pitch, to make minority pre-IPO investments in high-growth Chinese private sector companies then take them public in New York or Hong Kong.

All played by pretty much the same set of rules used by PE firms in the US and Europe: valuations would be set at a reasonable price-to-earnings multiple, often single digits, with the usual toolkit of downside protections. Due diligence was to be done according to accepted professional standards, usually by retaining the same Big Four accounting firms and consulting shops doing the same well-paid helper work they perform for PE firms working in the US and Europe. Deals got underwritten to a minimum IRR of about 25%, with an expected hold period of anything up to ten years.

There were some home-run deals done during this time, including investments in companies that grew into some of China’s largest and most profitable: now-familiar names like Baidu, Alibaba, Pingan, Tencent. It was a very good time to be in the China PE and VC game – perhaps a little too good. Chinese government and financial institutions began taking notice of all the money being made in China by these offshore dollar-investing entities. They decided to get in on the action. Rather than relying on raising dollars from LPs outside China, the domestic PE and VC firms chose to raise money in Renminbi (RMB) from investors, often with government connections, in China. Off the bat, this gave these new Renminbi funds one huge advantage. Unlike the dollar funds, the RMB upstarts didn’t need to go through the laborious process of getting official Chinese government approval to convert currency. This meant they could close deals far more quickly.

Stock market liberalization and the birth of a strategy

Helpfully, too, the domestic Chinese stock market was liberalized to allow more private sector companies to go public. Even after last year’s stock market tumble, IPO valuations of 70X previous year’s net income are not unheard of. Yes, RMB firms generally had to wait out a three-year mandated lock-up after IPO. But, the mark-to-market profits from their deals made the earlier gains of the dollar PE and VC firms look like chump change. RMB funds were off to the races.

Almost overnight, China developed a huge, deep pool of institutional money these new RMB funds could tap. The distinction between LP and GP is often blurry. Many of the RMB funds are affiliates of the organizations they raise capital from. Chinese government departments at all levels – local, provincial and national – now play a particularly active role, both committing money and establishing PE and VC funds under their general control.

For these government-backed PE firms, earning money from investing is, at best, only part of their purpose. They are also meant to support the growth of private sector companies by filling a serious financing gap. Bank lending in China is reserved, overwhelmingly, for state-owned companies.

A global LP has fiduciary commitments to honor, and needs to earn a risk-adjusted return. A Chinese government LP, on the other hand, often has no such demand placed on it. PE investing is generally an end-unto-itself, yet another government-funded way to nurture China’s economic development, like building airports and train lines.

Chinese publicly-traded companies also soon got in the act, establishing and funding VC and PE firms of their own using balance sheet cash. They can use these nominally-independent funds to finance M&A deals that would otherwise be either impossible or extremely time-consuming for the listed company to do itself. A Chinese publicly-traded company needs regulatory approval, in most cases, to acquire a company. An RMB fund does not.

The fund buys the company on behalf of the listed company, holding it while the regulatory approvals are sought, including permission to sell new shares to raise cash. When all that’s completed, the fund sells the acquired company at a nice mark-up to its listed company cousin. The listco is happy to pay, since valuations rise like clockwork when M&A deals are announced. It’s called “market cap management” in Chinese. If you’re wondering how the fund and the listco resolve the obvious conflicts of interest, you are raising a question that doesn’t seem to come up often, if at all.

Peter continues his discussion of the growth of Renminbi funds next week. Stay tuned! He also moderates our SuperReturn China 2016 Big Debate: ‘How Do You Best Manage Your Exposure To China?’.

http://www.superreturnlive.com/

China 2015 — China’s Shifting Landscape — China First Capital new research report published

China First Capital research report

 

Slowing growth and a gyrating stock market are the two most obvious sources of turbulence in China at the midway point of 2015. Less noticed, perhaps, but certainly no less important for China’s long-term development are deeper trends radically reshaping the overall business environment. Among these are a steady erosion in margins and competitiveness in many, if not most, of China’s industrial and service economy. There are few sectors and few companies that are enjoying growth and profit expansion to match last year and the years before.

China’s consumer market, while healthy overall, is also becoming a more difficult place for businesses to earn decent returns. Relentless competition is one part. As problematic are rising costs and inefficient poorly-evolved management systems.  From a producer economy dominated by large SOEs, China is shifting fast to one where consumers enjoy vastly more choice, more pricing leverage and more opportunities to buy better and buy cheaper. Online shopping is one helpful factor, since it allows Chinese to escape from the poor service and high prices that characterize so much of the traditional bricks-and-mortar retail sector. It’s hard to find anything positive to say about either the current state or future prospects for China’s “offline economy”.

Meanwhile, more Chinese are taking their spending money elsewhere, traveling and buying abroad in record numbers. They have the money to buy premium products, both at home and abroad. But, too much of what’s made and sold within China, belongs to an earlier age. Too many domestic Chinese companies are left manufacturing products no longer quite meet current demands. Adapting and changing is difficult because so many companies gorged themselves previously on bank loans. Declining margins mean that debt service every year swallows up more and more available cash flow. When the economy was still purring along, it was easier for companies and their banks to pretend debt levels were manageable. In 2015, across much of the industrial economy, the strained position of many corporate borrowers has become brutally obvious.

These are a few of the broad themes discussed in our latest research report, “China 2015 — China’s Shifting Landscape”. To download a copy click here.

Inside, you will not find much discussion of GDP growth or the stock market. Instead, we try here to illuminate some less-seen, but relevant, aspects of China’s changing business and investment environment.

For those interested in the stock market’s current woes, I can recommend this article (click here) published in The New York Times, with a good summary of how and why the Chinese stock market arrived at its current difficult state. I’m quoted about the preference among many of China’s better, bigger and more dynamic private sector companies to IPO outside China.

In our new report, I can point to a few articles that may be of special interest, for the signals they provide about future opportunities for growth and profit in China:

  1. China’s most successful cross-border M&A ever, General Mills of the USA acquisition and development of dumpling brand Wanchai Ferry (湾仔码头), using a strategy also favored by Nestle in China
  2. China’s new rules and rationale for domestic M&A – “buy first and pay later”
  3. China’s most successful, if little known, recent start-up, mobile phone brand OnePlus – in its first full year of operations, 2015 worldwide revenues should reach $1 billion, while redefining positively the way Chinese brand manufacturers are viewed in the US and Europe
  4. Shale gas – by shutting out most private sector investment, will China fail to create conditions to exploit the vast reserves, larger than America’s, buried under its soil?
  5. Nanjing – left behind during the early years of Chinese economic reform and development, it is emerging as a core of China’s “inland economy”, linking prosperous Jiangsu and Shanghai with less developed heavily-populated Hubei, Anhui, Sichuan

We’re at a fascinating moment in China’s story of 35 years of rapid and remarkable economic transformation. The report’s conclusion: for businesses and investors both global and China-based, it will take ever more insight, guts and focus to outsmart the competition and succeed.

 

China’s Incendiary Market Is Fanned by Borrowers and Manipulation — The New York Times

NYT

China’s Incendiary Market Is Fanned by Borrowers and Manipulation

The China IPO Embargo: How and When IPOs May Resume

China IPO

China first slowed its IPO machinery beginning July 2012 and then shut it down altogether almost a year ago. Since then, about the only thing stirring in China’s IPO markets have been the false hopes of various analysts, outside policy experts, stockbrokers, PE bosses, even the world’s most powerful investment bank.  All began predicting as early as January 2013 the imminent resumption of IPOs.

So here we are approaching the end of September 2013 with still no sign of when IPOs will resume in China. What exactly is going on here? Those claiming to know the full answer are mainly “talking through their hat“. Indeed, the most commonly voiced explanation for why IPOs were stopped — that IPOs would resume when China’s stock markets perked up again, after two years of steady decline — looks to be discredited. The ChiNext board, where most of China’s private companies are hoping to IPO, has not only recovered from a slump but hit new all-time highs this summer.

Let me share where I think the IPO process in China is headed, what this sudden, unexplained prolonged stoppage in IPOs has taught us, and when IPOs will resume.

First, the prime causal agent for the block in IPOs was the discovery in late June last year of a massive fraud inside a Chinese company called Guangdong Xindadi Biotechnology.  (Read about it here and here.)

This one bad apple did likely poison the whole IPO process in China, along with the hopes of the then-800 companies on the CSRC waiting list. They all had underwriters in place, audits and other regulatory filings completed and were waiting for the paperwork to be approved and then sell shares on the Shenzhen or Shanghai stock exchanges. That was a prize well worth queuing up for. China’s stock markets were then offering companies some of the world’s highest IPO valuations.

After Xindadi’s phony financials were revealed and its IPO pulled, the IPO approval process was rather swiftly shut down. Since then, the CSRC has gone into internal fix-it mode. This is China, so there are no leaks and no press statements about what exactly is taking place inside the CSRC and what substantive changes are being considered. We do know heads rolled. Xindadi’s accountants and lawyers have been sanctioned and are probably on their way to jail, if they aren’t there already A new CSRC boss was brought in, new procedures to detect and new penalties to discourage false accounting were introduced.  The waiting list was purged of about one-third of the 800 applicants. No new IPO applications have been accepted for over a year.

IPOs will only resume when there is more confidence, not only within the CSRC but among officials higher up, that the next Xindadi will be detected, and China’s capital markets can keep out the likes of Longtop Financial and China MediaExpress, two Chinese companies once quoted on NASDAQ exchange. They, along with others, pumped up their results through false accounting, then failed spectacularly.  Overall, according to McKinsey, investors in U.S.-listed Chinese companies lost 72% of their investment in the last two years.

China’s leadership urgently does not want anything similar to occur in China. That much is certain. How to achieve this goal is less obvious, and also the reason China’s capital market remains, for now, IPO-less.

If there were a foolproof bureaucratic or regulatory way for the CSRC to detect all fraudulent accounting inside Chinese companies waiting to IPO in China,  the CSRC would have found it by now. They haven’t because there isn’t. So, when IPOs resume, we can expect the companies chosen to have undergone the most forensic examination practiced anywhere. The method will probably most approximate the double-blind testing used by the FDA to confirm the efficacy of new medicines.

Different teams, both inside the CSRC and outside, will separately pour over the financials. Warnings will be issued very loudly. Anyone found to be book-cooking, or lets phony numbers get past him,  is going to be dealt with harshly. China, unlike the US, does not have “country club prisons” for white collar felons.

The CSRC process will turn several large industries in China into IPO dead zones, with few if any companies being allowed to go public. The suspect industries will include retail chains, restaurants and catering, logistics, agricultural products and food processing. Any company that uses franchisees to sell or distribute its products will also find it difficult, if not impossible, to IPO in China. In all these cases, transactions are done using cash or informal credit, without proper receipts. That fact alone will be enough to disqualify a company from going public in China.

Pity the many PE firms that earlier invested in companies like this and have yet to exit. They may as well write down to zero the value of these investments.

Which companies will be able to IPO when the markets re-open? First preference will be for SOEs, or businesses that are part-owned by or do most of their business with SOEs. This isn’t really because of some broader policy preference to favor the state sector over private enterprise. It’s simply because SOEs, unlike private companies, are audited annually, and are long accustomed to paper-trailing everything they do. In the CSRC’s new “belt and suspenders” world, it’s mainly only SOEs that look adequately buckled up.

Among private companies, likely favorites will include high-technology companies (software, computer services, biotech), since they tend to have fewer customers (and so are easier to audit) and higher margins than businesses in more traditional industries. High margins matter not only, or even mainly, because they demonstrate competitive advantage. Instead, high margins create more of a profit cushion in case something goes wrong at a business, or some accounting issue is later uncovered.

The CSRC previously played a big part in fixing the IPO share price for each company going public. My guess is, the CSRC is going to pull back and let market forces do most of the work. This isn’t because there’s a new-found faith in the invisible hand. Simply, the problem is the CSRC’s workload is already too burdensome. Another old CSRC policy likely to be scrapped: tight control on the timing of all IPOs, so that on average, one company was allowed to IPO each working day. The IPO backlog is just too long.

The spigot likely will be opened a bit. If so, IPO valuations will likely continue to fall. From a peak in 2009, valuations on a p/e basis had already more than halved to around 35 when the CSRC shut down all IPOs.  IPO valuations in China will stay higher than, for example, those in Hong Kong. But, the gap will likely go on narrowing.

What else can we expect to see once IPOs resume? Less securitized local government borrowing. Over the last 16 months, with lucrative IPO underwriting in hibernation,  China’s investment banks, brokerage houses and securities lawyers all kept busy by helping local government issue bonds. It’s a low margin business, and one not universally approved-of by China’s central government.

How about things that will not change from the way things were until 16 months ago? The CSRC will continue to forbid companies, and their brokers, from doing pre-IPO publicity or otherwise trying to hype the shares before they trade. If first day prices go up or down by what CSRC determines is “too much”, say by over 15%, expect the CSRC to signal its displeasure by punishing the brokerage houses managing the deals.  The CSRC is the lord and master of China’s IPO markets, but a nervous one, stricken by self-doubt.

China needs IPOs because its companies need low-cost sources of growth capital. When IPOs stopped, so too did most private equity investment in China. It’s clear to me this collapse in equity funding has had a negative impact on overall GDP, and Chinese policy-makers’ plans to rebalance its economy away from the state-owned sector. It’s a credit to China’s overall economic dynamism, and the resourcefulness of its entrepreneurs,  that economic growth has held up so well this past 18 months.

IPOs in China are a creature of China’s administrative state. Companies, investors, bankers, are all mainly just bystanders. Right now, the heaviest chop to lift in China’s bureaucracy may be the one to stamp the resumption of IPOs. So, when exactly will IPOs resume? Sometime around Thanksgiving (November 24, 2013) would be my guess.

 

 

China PE value-added: Empty promises? AVCJ

Fin

Author: Tim Burroughs

Asian Venture Capital Journal | 22 May 2013 | 15:47 secure

Tags: Gps | China | Operating partners | Buyout | Growth capital |Lunar capital management | Cdh investments management | Citic capital partners | Kohlberg kravis roberts & co. (kkr) | Jiuding Capital | Hony capital

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       China value-add: Empty promises?

Pulled by a desire to buy and build or pushed by a need to address restricted exit options, PE firms in China are placing greater emphasis on operational value-add. LPs must decide who’s all talk and who is action

By the time Harvard Business School published its case study of Kunwu Jiuding Capital in December 2011, the investment model being celebrated was already fading.

Within four years of its launch, the private equity firm had amassed $1 billion in funds and 260 employees, having turned itself into a PE factory “where investment activities were carried out in a way similar to large-scale industrial production.” Jiuding’s approach focused on getting a company to IPO quickly and leveraging exit multiples available on domestic bourses; and then repeating the process several dozen times over. With IRRs running to 500% or more, an army of copycats emerged as renminbi fundraising jumped 60% year-on-year to $30.1 billion in 2012.

But the average price-to-earnings ratio for ChiNext-listed companies had slipped below 40 by the end of 2011, compared to 129 two years earlier; SME board ratios were also sliding. Already denied the multiples to which they were accustomed, nearly a year later these pre-IPO investors were denied any listings at all as China’s securities regulator froze approvals.

The Harvard Business School case study noted that concerns had been raised about the sustainability of the quick-fire approach, given that some of these GPs appeared to lack the skills and experience to operate in normalized conditions. “The short-term mentality creates volatility,” Vincent Huang, a partner at Pantheon, told AVCJ in October 2011. “A lot of these GPs don’t have real value to add and so they won’t be in the market for the long run.”

Subsequent events have elevated the debate into one of existential proportions for pre-IPO growth capital firms. Listings will return but it is unclear whether they will reach their previous heights: the markets may be more selective and the valuations more muted.

There is also a sense that GPs have been found out lacking a Plan B; renminbi fundraising dropped to $5.1 billion in the second half of 2012. The trend is reflected on the US dollar side as the slowdown in Hong Kong listings over the course of the year left funds with ever decreasing certainty over portfolio exits. If GPs – big or small – face holding a company for longer than expected, what are they going to do with it?

“We value control and we can take advantage of the M&A markets if we have it. We also like the IPO markets here but any investment where we aren’t a controlling shareholder, we can’t set down the timetable for exit,” says H. Chin Chou, CEO of Morgan Stanley Private Equity Asia. “We ask ourselves, ‘Do we like holding this investment for five years because there is no IPO? At some point the IPO market will come back but until then you have to be very comfortable holding it.”

More…

 

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

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.

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Goldman Sachs Predicts 349 IPOs in China in 2013 — Brilliant Analysis? Or Wishful Thinking?

We’re one-quarter of the way through 2013 and so far no IPOs in China. Capital flows to private companies remain paralyzed. Never fear, says Goldman Sachs. In a 24-page research report published January 23rd of this year (click here to read an excerpt), Goldman projects there will be 349 IPOs in China this year, a record number. Its prediction is based on Goldman’s calculation that 2013 IPO proceeds will reach a fixed percentage (in this case 0.7%) of 2012 year-end total Chinese stock market capitalization.

This formula provides Goldman Sachs with a precise amount of cash to be raised this year in China from IPOs: Rmb 180bn ($29 billion), an 80% increase over total IPO proceeds raised in China last year. It then divvies up that Rmb 180 billion into its projected 349 IPOs,  with 93 to be listed in China’s main Shanghai stock exchange, 171 on the SME board in Shenzhen, and 85 on the Chinext (创业板)exchange. To get to Goldman’s numbers will require levels of daily IPO activity that China has never seen.

The report features 35 exhibits, graphs, charts and tables, including scatter plots, cross-country comparisons, time series data on what is dubbed “IPO ratios (IPO value as % of last year-end’s total market cap)”. It’s quite a statistical tour de force, with the main objective seeming to be to allay concerns that too many new IPOs in China will hurt overall China share price levels. In other words, Goldman is convinced a key issue that is now blocking IPOs in China is one of supply and demand. The Goldman calculation, therefore, shows that even the 349 new IPOs, taking Rmb180 billion in new money from investors, shouldn’t have a particularly adverse impact on overall share price levels in China.

I’ve heard versions of this analysis (generally not as comprehensive or data-driven as Goldman’s) multiple times over the last year, as China IPO activity first slowed dramatically, then was shut down completely six months ago. The CSRC itself has never said emphatically why all IPOs have stopped. So, everyone, including Goldman,  is to some extent guessing. Goldman’s guess, however, comes accessorized with this complex formula that uses December 31, 2012 share prices as a predictor for the scale of IPOs in 2013.

I’m grateful to a friend at China PE firm CDH for sending me the Goldman report a few days ago. I otherwise wouldn’t have seen it. I’m not sure if Goldman Sachs released any follow-up reports or notes since on China IPOs. Goldman was the first Wall Street firm to win an underwriting license in China. It’s impossible to say how much Goldman’s business has been hurt by the near-year-long drought in China IPOs.

Goldman shows courage, it seems to me, in making a precise projection on the number of IPOs in China this year, and relying on their own mathematical equation to derive that number. Here’s how all IPO activity in China since 1994 looks when the Goldman formula is plotted:

 

 

 

 

 

 

 

 

 

 

 

I’m not a gambling man, and personally hope to see as many IPOs as possible this year of Chinese companies. Even a fool knows the easiest way to lose money in financial markets is to be on the other side of a bet with Goldman Sachs. That said, I’m prepared to take a shot.  I’d be delighted to make a bet with the Goldman team that wrote the report. A spread bet, with “over/under” on the 349 number. I take the “under”. We settle up on January 1, 2014. Any takers?

My own guess – and that’s all it is –  is that there will be around 120 IPOs in China this year. But, this prediction admittedly does not rely on any formula like Goldman Sachs and so lacks exactitude. In fact, I approach things from a very different direction. I don’t think the only, or even main,  reason there are no IPOs in China is because of concerns about how new IPOs might impact overall share prices.

I put as much, or more, importance on rebuilding the CSRC’s capacity to keep fraudulent companies from going public in China. The CSRC seems to have had quite stellar record in this regard until last summer, when a company called Guangdong Xindadi Biotechnology got through the CSRC approval process and was in the final stages of preparing for its IPO. Reports in the Chinese media began to cast doubt on the company and its finances. Within weeks, the Xindadi IPO was pulled by the CSRC. The company and its accountants are now under criminal investigation.

The truth is still murky. But, if press reports are to be believed, even in part, Xindadi’s financial accounts were as fraudulent as some of the more notorious offshore Chinese listed companies like Sino-Forest and Longtop Financial targeted by short sellers and specialist research houses in the US.  The CSRC process — with its multiple levels of “double-blind” control, audit, verification —   was designed to eliminate any potential for this sort of thing to happen in China’s capital markets.

But, it seems to have happened. So, in my mind, getting the CSRC IPO approval process back on track is a key variable determining when, and how many, new IPOs will occur this year in China. This cannot be rendered statistically. The head of the CSRC was just moved to another job, which complicates things perhaps even more and may lead to longer delays before IPOs are resumed and get back to the old levels.

How far is the CSRC going now to try to make its IPO approval process more able to detect fraud? It has instructed accountants and lawyers to redo, at their own expense, the audits and legal diligence on companies they represent now on the CSRC waiting list.  Over 100 companies just dropped off the CSRC IPO approval waiting list, leaving another 650 or so stranded in the approval process, along with the 100 companies that have already gotten the CSRC green light but have been unable to complete their IPO.

A friend at one Chinese underwriter also told us recently that meetings between CSRC officials, companies waiting for IPO approval and their advisers are now video-taped. A team of facial analysis experts on the CSRC payroll then reviews the tapes to decide if anyone is telling a lie. If true, it opens a new chapter in the history of securities regulation.

If, as I believe,  restoring the institutional credibility of the CSRC approval process is a prerequisite for the resumption of major IPO activity in China, a statistical exhibit-heavy analysis like Goldman’s is only going to capture some, not all, of the key variables. Human behavior, fear of punishment, organizational function and dysfunction, as well as darker psychological motives also play a large role. An expert in behavioral finance might be more well-equipped to predict accurately when and how many IPOs China will have this year than Goldman’s crack team of portfolio strategists.

China Private Equity Secondaries — the new China First Capital research report

 

In the current difficult market environment for private equity in China, secondary transactions provide a valuable way forward.  Staging successful IPOs or M&A will remain severely challenging. This is the conclusion of a proprietary research report recently completed and published by China First Capital. An abridged version is available by clicking here.  You can also visit the Research Reports section of the China First Capital website.

Secondaries potentially offer some of the best risk-adjusted investment opportunities, as well as the most certain and efficient way for private equity and venture capital firms to exit investments. And yet these secondary deals still remain rare. As a result, General Partners, Limited Partners and investee companies, as well as China’s now-large private equity industry,  are all at risk from serious adverse outcomes.

This new CFC research report is a data-driven examination of the potential market for secondary transactions in China, the significant scope for profit on all sides of the transaction, as well as the no less significant obstacles to the development of an efficient, liquid, stable long-term market in these secondary positions in China.

The report’s conclusion is that secondaries have the potential to benefit all three core constituencies in the China PE industry — GPs, LPs and investee companies. The universe of deals potentially available for secondary exit is large, over 7,500 unexited investments made in China by PE firms since 2000.

However, the greatest potential for both PE sellers and buyers across the short to medium term is in a group of select companies CFC terms “Quality Secondaries“. These are PE investments that fulfill four criteria:

  1. unexited and not in IPO approval process, domestically or internationally
  2. investee companies have grown well (+25% a year) since the original round of PE investment, and have continuing scope to expand enterprise value and achieve eventual capital markets or trade sale exit in 3-6 year time frame
  3. businesses are sound from legal and regulatory perspective, have effective corporate governance, and a majority owner  that will support secondary sale to another PE institution
  4. current PE investor seeks secondary exit because of fund life or portfolio management reasons

CFC’s  analysis reveals that the potential universe of “Quality Secondaries” is at least 200 companies. This number will likely grow by approx. 15%-25% a year, as funds reach latter stage of their lives and if other exit options remain limited.

At the current juncture, in this market environment, and assuming “Quality Secondary” deals are done at market valuations, these investment represent some of the better values to be found in growth capital investing in China.  DD risk is significantly lower than in primary deals, and contingent risks (opportunity costs, and legal risks of pursuing other non-IPO exits) are lower.

Despite the current lack of significant deal-making activity in this area, secondaries will likely go from current low levels to gain a meaningful share of all PE exits in China.

The secondaries market in China will have unique factors compared to the US, Europe and elsewhere. There will likely be limited investor interest in any secondary deal involving a Chinese company or a portfolio that has underperformed since PE investment, or could otherwise be characterized as a  “distress” situation.

Quality Secondaries transactions in China will involve PE investors “cherry-picking” good companies at fair valuations.  The primary motivation for selling PEs is misalignment between its remaining fund life and the time required and risk inherent in achieving  domestic or offshore IPO or trade sale exit during that shortened time frame.

In contrast with secondary deals done outside China, we do not expect to see much activity involving the sale of all or most of a PE firm’s portfolio of investments. Specialist secondary firms operating elsewhere (e.g. Coller Capital, Harbourvest) do not currently have the experience or manpower in China to take on the complexities of managing and liquidating all or most of an existing portfolio of minority investments.

Rather, we expect those PEs with strong operating performance in growth capital investing in China to exploit favorable market conditions by becoming active buyers of Quality Secondaries.   GPs that prefer larger deals, (+USD25mn/Rmb200mn), should be particularly interested in Quality Secondaries, since company scale and investment amount will likely be larger, on average, than primary deals in China.

Selling PEs can pursue exit strategies based on option of selling either part or all of a successful unexited deal. A part liquidation in Quality Secondary transaction can mitigate risk and return capital to LPs while still retaining future upside. A full exit through secondary can increase fund’s realized IRR and so assist future fundraising. Importantly, a selling PE needs to act before pricing leverage is transferred mainly to buyers — generally this means secondary deals should be evaluated and priced in market when fund still has minimum of two years left of active period.

While clearly the most acute need for exit will be investments made before 2008, more recent investments need also to be assessed based on current market conditions. Many GPs are adopting what looks to be an unhedged strategy across a portfolio of invested deals waiting for capital markets conditions to improve.

In particular, much of this “wait and see” approach is based on the hope that Hong Kong’s once-vibrant, now-moribund IPO market for Chinese companies returns to its earlier state. The US stock market will certainly remain off limits to most Chinese companies for a long time to come. Exit through China’s domestic stock market is now seriously blocked by bureaucratic slowdowns and an approval backlog that even under optimistic scenarios could take three to five years to clear.

The need for diversification is no less paramount for exits than entries. Many of the same PEs that wisely spread their LPs money across a range of industries, stages and deal sizes, have become over-reliant now on  a single path to exit: the Hong Kong IPO.  By itself, such dependence on a single exit path is risky. In the current environment, it looks even more so.

The flood of Chinese IPOs in Hong Kong basically came to a halt a year ago.  When they do resume, it may prove challenging for all but the best and biggest Chinese companies to successfully issue shares there. What will become of the other deals? How will GPs and LPs profit from investments already made? That’s the focus on this new report, titled, “China Secondaries:  The Necessary & Attractive Exit For Private Equity Deals in China“.

 

Two New CFC Research Reports

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 Sartres 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

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

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.

 

 

 

A Bond Market for Private Companies in China

Capital allocation in China was built on a wobbly pedestal. One of its three legs was missing. Equity investment and bank lending were available. But, there was no legal way for private companies to issue bonds.  That has now changed. In May this year, the Chinese government approved the establishment of a market for private company bonds in China. This is an important breakthrough, the most significant since the launch three years ago by the Shenzhen Stock Exchange of the Chinext board (创业板) for high-growth private companies. The new bond market has the potential to dramatically increase the scale of funding for private business in China.

Companies can issue bonds through a group of approved underwriters in China, who place the bonds with Chinese institutions. The bonds then trade on secondary markets established by both the Shenzhen or Shanghai stock exchanges. Bonds should lower the cost of capital for Chinese companies, and provide attractive returns for fixed-income investors. Another positive effect: the bonds disintermediate Chinese banks, which for too long have overcharged and under-served private company borrowers.

Up to now, though, China’s private company bond market is off to a bumpy start. Regulators are over-cautious, investors are inexperienced, companies are confused, the secondary markets are lacking in liquidity. We have no direct involvement in the private company bond market. We don’t issue or trade these instruments. But, we are eager to see private company bonds succeed in China. It will increase the capital available for good companies, and allow companies to achieve a more well-balanced capital structure. Capital remains in very short supply. Many PE firms in China have recently cut back rather dramatically in their funding to private companies, because of a decline in China’s stock market and a marked slowdown in the number of IPOs approved in China.

We recently prepared for the Chinese entrepreneurs we work with a short briefing memo on private company bonds. It’s in Chinese. The title is  “中国中小企业私募债”. You can download a copy by clicking here.

We explain some of the practical steps, as well as the potential benefits, for companies interested to float bonds. At the moment, only companies based in a handful of China’s more economically-advanced provinces (including Shanghai, Guangdong, Zhejiang, Jiangsu) may issue the bonds. Most underwriters expect the geographical limitations to ease, over the next year, allowing companies in all parts of the country to participate. There is no clear threshold on how big a company must be to issue bonds. But, there is a clear preference for larger businesses, with profits of at least Rmb20mn (USD$3mn). In several cases, underwriters have pooled together several smaller companies into a single bond issue. Real estate developers, currently hurting because of the cut-off in bank lending to this industry, are not eligible to issue bonds.

In theory, a company can issue bonds without offering collateral or third-party loan guarantees, both of which are required by banks to secure a typical short-term corporate loan. In practice, however, the market is signaling strongly it prefers these kinds of risk protections. Interest rates on some of the private company bonds already issued have been below the levels typically charged by banks for secured lending. But, the rate is starting to move up, to over 10%. My guess is that interest rates for good borrowers should move back below 10%. That level offers bondholders a very solid real rate of return, and prices in the risk. In the US and Europe, decent companies can borrow at LIBOR+4-6%, or around 5%-7% a year.

Overall, as the new bond market expands and matures, we expect these bonds to offer the lowest cost of capital for growth companies in China. Bond maturities can be as long as three years;  interest and principal payments can be structured to accommodate future cash flows. This is generally far more suitable than the rigid short-term lending facilities available from Chinese banks.

Underwriters are promising companies they can complete the process of issuing a bond, including regulatory approvals, in three months or less. That’s remarkably quick for any capital markets transaction in China, and reflects the fact China’s finicky securities regulator, the CSRC, has no role in approving private company bonds. The Shanghai and Shenzhen stock markets regulate and approve bond issuance.

PE firms are starting to notice that access to bond market gives private companies more leverage and a little more pricing power when negotiating equity financing. The Chinese companies that can successfully issue bonds are generally the ones that PE firms also target.  Over time, though, PE firms should welcome the emergence of a functioning private company bond market in China.  The new bond market gives companies, including those with PE investment, an opportunity ahead of a domestic IPO to operate in the capital market, build a reputation for transparency and good performance. This should mean a higher IPO valuation if and when the company does decide to go public.

 

 

Private Equity Valuation: Terminal Multiple Is All That Matters

A lot gets written, and even more gets discussed, about how to value private companies for the purposes of PE or VC investment. There is an awful lot of “Mongolian talk” going around, a translation of the Chinese term, 胡说 , meaning senseless drivel. PEs often use irrelevant or misleading comps to justify a lowball valuation. Companies are no less guilty, setting their valuation expectations unrealistically high, based on hear-say about other deals being done or a misreading of current stock market p/e multiples.

So, how do you work out a fair valuation? The only way I know is if both sides agree on the same set of facts to advance from. That is already challenge enough. How big a challenge?

Below, I share part of an email memo I sent to a large Chinese industrial equipment manufacturer. Their controlling shareholder hopes to sell down some of its shares, while also raising some new capital for the business. They are a sophisticated group, with strong management. They approached several investment banks, including ours, to represent them in the capital raising. We made the final cut, and they then insisted that the advisor they choose must achieve a valuation for them of at least 10X this year’s net income.

In more than just the two words “that’s unreasonable”,  I set out why they need to be more accommodating with reality.

“Your goal, which I thoroughly share, is to bring in a first-rate PE and get the best price for a valuable asset. I would work with all my diligence to achieve that.  But, let’s look frankly and factually at current market conditions. At the moment, domestically-listed Chinese companies in [your]  industry are trading at a trailing p/e of 28X and forward (this year’s) p/e of 22x. Both have fallen by approx. one-third in the last year. (The 22X is the basis we should use, to compare like-with-like. You have set your valuation target of +10X based on this year’s net income.) 

Your valuation target of +10X is a discount to quoted comps of 50% or narrower. That is a smaller discount, and so higher entry valuation for PE firms, than deals being done now. 

As you know, all PE deals, since they involve illiquid companies often years away from IPO exit, are always done at discount to quoted comps. The discount is not fixed, but the only time PE deals were closed routinely at prices over 10X (rarely if ever above 15X) was two years ago or more when comparable stock market p/e valuations (generally on the CHINEXT)  were 70X-100X previous year’s net.   A rich price indeed, and for a while, it had a levitating effect on PE valuations.

Current market conditions are that there are no investments from first-line PEs with terminal multiples at +10X. I emphasize the word “terminal multiple” because quite often — too often in our experience — a PE will offer a higher multiple at term sheet stage, to win the competitive right to pursue exclusive due diligence. These deals are almost always “repriced” at closing to a level below 10X, when PE firm has most of the leverage. PE will claim they turned up “new facts” in DD, as they always do, that justify the repricing.  They promise you +10x in a term sheet knowing they will only close the deal at a lower price, when all other interested investors have vanished from the scene. Unfair? Duplicitous? Get used to it. It’s the way the game is played.

The other common occurrence in China PE is that there is a headline multiple of +10X but it is linked to an aggressive next year + this year (sometime even three year) profit guarantee. The level is set by PE firm in full expectation that company will not meet the profit targets, so triggering the ratchet, often quite punitive. This process will bring the terminal multiple down significantly. We’ve seen and heard of deals where this terminal multiple is half the headline number at signing of term sheet or Share Purchase Agreement. In other words, the SPA has a headline multiple of 12X, but terminal multiple, after ratchet is triggered,  works out to 6X-7X.

From my experience, the ratchet is triggered in over half PE deals done in China. In the case of some leading China PEs, [names omitted to shield the guilty], the ratchet is triggered in over 80% of the deals they do. The ratchet trigger is very unfortunate for the company, and reflects the fact they are badly advised, by advisory firms paid a fee based on “headline valuation at closing” not terminal valuation.  

The other condition attached to deals with headline p/e of +10X is a high IRR (usually +20% p.a. simple interest) for buybacks triggered by “no qualifying IPO”. The buyback is a feature of almost all PE deals done in China. As you would be financially liable for such a payment, if I work as your investment banker, I’d want to negotiate this mechanism very carefully with PE, to assure your best interests are fully protected. It’ll mean a fight with the PE firms, but it will be gentlemanly. You want an IRR of no more than 10%. Why? One way to think of it is that for every 100 basis points the buyout IRR is fixed above LIBOR, you can argue the terminal multiple falls by 0.3X to 0.5X, because of the contingent liability.  

Yours is a highly cyclical industry. We are now in the downward loop, heading for the bottom of cycle. This negatively impacts valuation. Your cap table, particularly the fact the company is controlled by a CEO who has no capital directly invested in the business, also negatively impacts valuation. For last three years (2009, 2010, 2011) your net income has been flat, and net margins have fallen by almost half. This too negatively impacts valuation.  That’s three strikes already. You’re not “out”, as in baseball. But, it’s a three-ton weight pushing down your terminal multiple. 

I can promise you that if we work together, you will get the best outcome available in current marketplace, and be working with a firm that shares your commitment to integrity, professionalism and accountability.  

But, if you do decide to move forward with the other advisor, I’d urge you to ask them to address the specific points raised here, and structure their compensation on an “all or nothing” basis: they only earn a fee if the terminal multiple is above 10X, as they are now promising.  

A seller’s focus on valuation is understandable. But, too often in our experience, it can play into the hands of both the PE investor and your investment banker. Both will encourage your expectations knowing that the final bill on valuation will only be presented to you in two to three year’s time.  More often than not, only they will be feeling victorious at that point.

Cordially,
Peter”

This company decided to retain the other investment bank.