Growth Enterprise Market

The New Equilibrium – It’s the Best Time Ever to be a Chinese Entrepreneur

China Private Equity blog post

As I wrote the last time out, the game is changed in PE investing in China. The firms most certain to prosper in the future are those with ability to raise and invest renminbi, and then guide their portfolio companies to an IPO in China. For many PE firms, we’re at a hinge moment: adapt or die. 

Luckily for me, I work on the other side of the investment ledger, advising private Chinese companies and assisting them with pre-IPO capital raising. So, while the changes now underway are a supreme challenge for PE firms, they are largely positive for the excellent SME businesses I work with.

They now have access to a greater pool of capital and the realistic prospect of a successful domestic IPO in the near future. Both factors will allow the best Chinese entrepreneurs to build their businesses larger and faster, and create significant wealth for themselves. 

As my colleagues and me are reminded every day, we are very fortunate. We have a particularly good vantage point to see what’s happening with China’s entrepreneurs all over the country. On any given week, our company will talk to the bosses of five and ten private Chinese SME. Few of these will become our clients, often because they are still a little small for us, or still focused more on exports than on China’s burgeoning domestic market. We generally look for companies with at least Rmb 25 million in annual profits, and a focus on China’s burgeoning domestic market. 

For the Chinese companies we talk to on a regular basis, the outlook is almost uniformly ideal. China’s economy is generating enormous, once-in-a-business-lifetime opportunities for good entrepreneurs.

Here’s the big change: for the first time ever, the flow of capital in China is beginning to more accurately mirror where these opportunities are. 

China’s state-owned banks have become more willing to lend to private companies, something they’ve done only reluctantly in the past. The bigger change is there is far more equity capital available. Every week brings word that new PE firms have been formed with hundreds of millions of renminbi to invest.

The capital market has also undergone its own evolutionary change. China’s new Growth Enterprise Market, known as Chinext, launched in October 2009. In two months, it has already raised over $1 billion in new capital for private Chinese companies. 

In short, the balance has shifted more in favor of the users rather than the deployers of capital. That because capital is no longer in such short supply. This is among the most significant financial changes taking place in China today: growth capital is no longer the scarcest resource. As recently as a year ago, PE firms were relatively few, and exit opportunities more limited. Within a year, my guess is the number of PE firms and the capital they have to invest in private Chinese companies will both double. 

Of course, raising equity capital remains a difficult exercise in China, just as it is in the US or Europe. Far fewer than 1% of private companies in China will attract outside investment from a PE or VC fund. But, when the business model and entrepreneur are both outstanding,  there is a far better chance now to succeed.

Great business models and great entrepreneurs are both increasingly prevalent in China. I’m literally awestruck by the talent of the Chinese entrepreneurs we meet and work with – and I’ve met quite a few good ones in my past life as a venture capital boss and technology CEO in California, and earlier as a business journalist for Forbes

So, while life is getting tougher for the partners of PE firms (especially those with only dollars to invest), it is a better time now than ever before in Chinese history to be a private entrepreneur. That is great news for China, and a big reason why I’m so thrilled to go to work each day.  


Shenzhen’s New Growth Enterprise Market: Getting it Right, Right From the Start

 

China First Capital blog post -- Ming Dynasty jade bowl

 

“Manage people’s expectations. Then, exceed them.” That’s not a bad rule to live by, or management principle to apply in regulating China’s fast-moving capital markets. This past week, China Regulatory Securities Commission, the nation’s stock market regulator, moved one step closer to opening trading in the new, Shenzhen-based, Growth Enterprise Market. It’s been ten years in the planning. The names were finally announced of the first companies that will list on the new market when trading begins later in October. All are private SME, and several had pre-IPO private equity funding.

The total amount of capital this first crop of IPOs will raise is well above most earlier estimates. The original stated plan was for smaller companies to list on the GEM, which, in turn, suggested the GEM market would be only a marginal contributor of growth capital for private SME. The minimum requirement was set at just $1.5mn in aggregate profits over the last two years. Even at high Chinese multiples, firms of that size would struggle to raise more than $10mn in an IPO.

But, in something of a surprise, CSRC chose larger companies to be in the first group to list. It now looks like that the ten companies will raise a total of over $400mn when their IPOs close, or an average of $40mn each. This, in turn, points to a cumulative market capitalization for this first group of around $2 billion. That bodes well for the market’s long-term future. A larger market capitalization means more liquidity and so less volatility in the share price. This will help attract more capital to the new Shenzhen market, and to subsequent future IPOs there.

Bravo, I say! The CSRC may well get the formula right, and so prove that these smaller-capitalization “growth stock markets” can work, both for companies and investors.

Elsewhere, these growth stock markets have mainly failed in their stated purpose to create an efficient platform for smaller companies to attract investors and raise capital. Germany’s Neuer Markt shut down soon after it was created. The small-cap markets in Singapore and Hong Kong have been disappointments. Small-cap companies stayed small-cap companies, which is entirely contrary to the purpose of a “growth board” like this. The granddaddy of them all, America’s OTC Bulletin Board, has become an all-purpose dumping ground for shady American firms, stock manipulators, and, sadly, several hundred once-strong Chinese SME who listed there after taking very bad advice from self-interested advisors and brokers looking to make a quick buck.

It’s anybody’s guess how many companies will list on Shenzhen’s GEM this year, or next. There is a backlog of at least 100 that have applied, and been provisionally accepted by CSRC. One thing we know: each IPO in China will get its final approval as part of an orderly process that takes into account the performance of companies already listed on GEM, and stock prices trends overall.

The Shenzhen GEM shows every sign of beginning to fill a very large, very important funding gap in China. Assuming, as I hope, that CSRC continues its preference for companies able to raise at least $30mn-$40mn in a public listing, these IPOs will channel capital to companies who would otherwise find it very hard to come by. Most of the private equity and venture firms that we work with don’t write checks that large. They generally invest around $10mn-$25mn in pre-IPO equity capital to own 20%-30% of a private Chinese SME. These investments are done at valuations of around eight times last year’s profits. So, a GEM listing could become the best source of growth capital for an SME that already has achieved some success, has profits of over $10mn-$20mn a year, but is still too small for a main board listing, in China or outside.

The public markets have two big advantages over private equity financing: they offer much higher price-earnings valuations, and give shareholders a liquid market to trade their shares. On the other hand, for Chinese SME, staging an IPO in China always has a level of deep unpredictability. The CSRC makes all the decisions about which companies can IPO and when. So, SME can wait two years or more to apply, get approval, and then put the IPO proceeds in the bank. If that SME is now growing quickly, has outsized opportunities near-to-hand with a high rate of return, but can’t finance its growth internally or with bank debt, a round of private equity will almost certainly be the best route to follow.

Done right (see my earlier blog post, on Foshan Saturday ‘s IPO) a company’s market capitalization, when it eventually completes its IPO, can be at least three times larger than it is at present. That means the laoban gets richer (nothing wrong with that), and investors are happier, too, because of the increased liquidity and stability from the higher market cap at IPO.

I’m extremely positive about the role the GEM will play in helping to build even stronger private Chinese SME. The CSRC and Chinese government have taken over ten years to plan this new stock market, and learn from the mistakes of others. All signs now are that they have done so, and the GEM will gradually create a group of publicly-traded private companies that will go on to achieve far more impressive results in the future.

Shenzhen’s New Small-Cap Stock Market — A Faster Path to IPO. Not Always a Smarter Path

lichi painting from blog post by China First Capital

One of the main themes of the PE conference I attended last week in Shanghai was the launch of the Shenzhen Stock Exchange’s new Growth Enterprise Market “GEM”, for smaller-cap, mainly high-tech companies.

It’s been a long time in the planning – since at least 1999. In March 2008, China’s Prime Minister, Wen Jiabao, tried to kickstart the process and announced plans to open soon this second market in Shenzhen. Events then intruded – the credit crisis struck, financial markets tanked, and so plans for China’s GEM went into limbo.

Things are now back on track. Trading is likely to begin in October. At the conference, most of the speakers focused on hows and whys the GEM would open new opportunities for smaller companies to raise money from China’s capital market.

Overall, it’s a development I applaud. Private companies in China are often starved of growth capital, and the GEM will mean more of the country’s capital gets allocated to these businesses.

There is one aspect, however, of the GEM that I personally find a little less positive. It’s a small quibble, but my concern is that the opening of the GEM will lead still more Chinese companies to divert time and resources away from building their profits and market share and instead devote energy and cash towards going public. The smaller the company, the more potentially harmful this diversion of attention can be.

China is, to use a military analogy, a “target-rich environment”. Companies often have more opportunities than they have time or resources. This is the product of an economy growing very strongly (8% this year) and modernizing at lightning speed. Large companies can also suffer when they shift focus from gaining customers to gaining a public listing. But, they will usually operate in an established market with established customers. This gives them more of a cushion.

Smaller, high-tech companies don’t have as much leeway. For these companies (last year’s revenues under $5o million) the risk is that the time-consuming and expensive process of planning an IPO on GEM will severely impact current operations, causing it to miss chances to expand, and so lose out to better-focused competitors.

In other words, there’s a trade-off here that tends to get overlooked in all the excitement about the opening of this new stock market in China. The trade-off is between focusing on capital-raising and focusing on building your business.

In my experience, private Chinese companies are already often a little too fixated on an IPO. It’s the main reason so many have made the poor, and often fatal, choice to go public on the American OTCBB. The GEM, I fear, will add fuel to this fire. Often, the best choice for a fast-growing private Chinese company will be to ignore the many pitches they’ll hear from advisors to IPO, and hunker down by focusing on their business for the next year or two.

Yes, being a boot-strapped company is tough. There’s never enough cash around. I know this at first-hand, since along with running China First Capital, I’m also CEO of a boot-strapped security software company in California, Awareness Technologies. Our growth opportunities far exceed our ability to finance them. So, I can understand why the thought of raising an “easy” $5 million – $15 million by going public on the GEM is very attractive to any Chinese boss running a similar cash-short and opportunity-rich company.

But, capital always has a cost. In this case, the main costs will be both the cash paid to advisors and regulators, along with the indirect cost of being a beat slower to seize available opportunities to grow. In China at the moment, any slowness is not just a problem. It can be life-threatening. Every business here operates in a hyper-competitive marketplace.

Of course, any company that can raise money by going public on the GEM will eventually enjoy a big advantage over competitors. It will have the cash and the stronger balance sheet to finance growth. But, the IPO process in China remains far slower than in the US or Hong Kong. A company planning and funding its GEM IPO now, may need to wait two years or more to get all necessary approvals and so finally raise that money with an IPO. Meantime, competitors are, as Americans like to say, eating this company’s lunch.

It’s a discussion we often have with SME bosses – how to time optimally an IPO. A rule of thumb with IPOs is: “small is not beautiful.” Going public on the strength of still limited earnings and revenues will likely result in a small market cap. This can adversely affect share price performance, and so limit the company’s ability to raise additional equity capital. To avoid this trap, it’s often going to be better to wait. Let competitors get bogged down in IPO planning. You can then grow at their expense.

In one way, though, the establishment of the GEM market is an unqualified triumph. It sends the signal far and wide that private SME companies will play an ever larger role in fueling the growth of China’s economy.

 

 

.