Hong Kong

Most Thankless Well-Paid Job in China: Market Forecaster

Calligraphy from China First Capital blog post


Looking for a new career with plenty of growth potential, and low standards for success? Here’s one to consider: China market forecasting. Rapid economic growth and urbanization are both creating huge demand for market research predicting future areas for opportunity and profit. Pay is good. But, there’s another aspect to the job that will appeal to many: repeated failure is no obstacle. 

Market research is, of course, a treacherous profession anywhere. Predicting the future always is. But, in China, market forecasting is particularly hard. It’s mainly been distinguished by how often, and by how much, the predictions turn out to be wrong.  Market segments in China grow so quickly, so explosively, that it makes a fool of just about anyone trying to guess its economic future. 

I’m reminded frequently of this these days. We’re working on a complicated infrastructure financing. One of the central components of the deal is a now two-year-old forecast of car purchases and driving patterns in China. The forecast was prepared by a respectable outfit in Hong Kong, and my guess is that they charged quite a lot to do it. But, looking at the numbers now, they seem ridiculous, like numbers pulled out of thin air – which is probably what they were. The actual growth of car traffic and car purchases over the last two years in China has been much higher than these predictions. In other words, the forecasts weren’t off by a mile, but by a light year. 

Given that track record, it’s surprising these market forecasters can continue to pay the rent, let alone prosper. And yet they do. It’s a familiar paradox: we know projections are often wrong, and yet many business decisions, often with billions of dollars at stake, are made on them. It’s probably connected to what’s sometimes called “the scientific theory of management”, which tried to systematize complex business decisions into quanta of data.

It’s the same approach taught in business schools, and is certainly one of the reasons so few MBAs make successful entrepreneurs. A hunch is often a better tool in business than a spreadsheet. Indeed, I’ve yet to meet a successful entrepreneur who ran his business, or started out in life, based on a market forecast. 

In our case, we’re stuck using the projections on auto traffic, because there’s nothing else available. So, we send them out to investors with the guidance to take the projections with a grain of salt. If not a fistful. This creates its own set of problems, including frequently the request to do a new set of “up-to-date” projections. In other words, the solution to bad projections is – you guessed it — to commission more projections. As I said, it’s a great job, being a market forecaster. 

The errors in a bad projection become cumulative. The longer the time line, the more distorted the projections will usually become.  In our case, we’re using a 25-year projection. So, these sizable errors in the first years will propagate across time. Year by year, the forecast becomes less and less tethered to reality, like the NASA space probe that escaped its flight path, lost contact with Mission Control and ended up, as far as we know, drifting in galactic space. 

Most markets outside China are more stable, so projections, even when they are wrong, don’t diverge quite so much from the actual situation.  Car sales are a great example. They are booming in China. Everyone I meet in Shenzhen, across all social classes, either has a car, is taking driving lessons or plans to begin soon. GM just announced its car sales in July in China rose 77% from a year earlier. 

For several months this year, China has been the world’s largest car market, outpacing the US. A quick web search turns up a supposedly highly credible forecast, from 2008, claiming that China is “on track to become the world’s largest car market by 2020, according to J.D. Power.” In other words, J.D. Power said it would take 12 years. It didn’t even take two. 

The recession in the US is a contributing factor, of course. But, the forecasts also, quite obviously, guessed very wrong about the growth rate of auto sales in China.   These wrong guesses have real-world consequences, because they can impact today’s decisions on investment and employment. In our case, by underestimating the growth rate of auto sales over the last two years, the projected revenues over 25 years from a $300mn toll expressway project in China also come in much lower. How much lower is anyone’s guess. Mine is that the revenue projections are off by at least 80% over the 25 years, and that this particular project will generate a profit of over $2 billion over that time, rather than the $1.2bn in the forecast built on the Hong Kong market researcher’s two year-old guesses. If so, the annual return on investment goes from the outstanding  to stratospheric. 

Here are my two projections: despite a record often unblemished by success, market forecasters in China will continue to ply their particular craft, collect their fees, sell their reports, and mainly miss the mark. Meanwhile, markets in China will continue to grow very fast, for a very long time. 




A Gathering of Friends: Celebrating a Friendship Forged by a Successful PE Deal

Imperial portrait from China First Capital blog post

Of all the rewards of completing a successful financing, the most overrated are the pecuniary ones, and most underappreciated are the deep and lasting friendships that can result. I was reminded of this, vividly, on Friday. I shared a few very happy hours with the three other principals in the $10 million private equity financing we completed last November: Zheng Shulin, the owner and founder of Kehui International,  Elliott Chen, Kehui’s lawyer, and Ada Yu, a Vice President at the PE firm CRCI. 

We got together in Shenzhen to participate in a seminar at the Nanshan Venture Capital Club. The purpose was to give other entrepreneurs in Shenzhen a better understanding of the mechanics, timing and financial fundamental of pre-IPO PE investment in China. It was a very happy reunion. We hadn’t met as a group since last November. In the intervening months, Ada went on maternity leave and gave birth to twin daughters, while Mr. Zheng has been busy completing construction on the new factory in Jiangxi the PE investment enabled. The new factory will allow Kehui to more than double its output and become a dominant supplier of copper and aluminum-coated wires for use in electronics industry. 

There’s a nice symmetry here, of course: Ada’s twins and Mr. Zheng’s new factory got their starts at just about the same time last summer. That’s as far as I’ll go with the metaphor, since I’m sure Mr. Zheng will concede, despite his evident pride in his new factory, that Ada’s twins are the far more momentous creation. 

I was so happy and so moved by the whole experience on Friday, of being back together with Mr. Zheng, Elliott and Ada, and having a chance to “re-live” some of the experience in front of a crowd of about 70 at the seminar. Mr. Zheng shared one of the nicest stories from the closing: we were stuck at the final hurdle for over a month, waiting for government financial regulators in Jiangxi. They’d never before been asked to approve a foreign investment of this scale in their province, and so didn’t really know the rules or how to apply them. It looked like Jiangxi’s approval process could take months, and so cost Mr. Zheng the chance to get the new factory underway and meet surging orders. 

Mr. Zheng camped out in Nanchang, Jiangxi’s capital, to try to persuade the government officials.  I decided to visit CRCI’s office in Hong Kong to work out an agreement to advance the money ahead of the government’s final approval. CRCI’s partner agreed to do so, even though it could increase their risk in the deal. At the same moment I was dialing Mr. Zheng to give him the good news, he phoned me from Nanchang, Jiangxi’s capital, to say he’d just been given the final okay.  I returned to CRCI’s office a short time after, with Mr. Zheng, to sign the closing documents. The money arrived two weeks later.   

A big part of the credit belongs to Elliott Chen, since he both wrote the legal briefs, and spent the long hours explaining to Jiangxi officials how to apply the relevant national laws on foreign exchange transactions. A lesson here: in China, the national government in Beijing crafts very clear and often forward-thinking financial laws, but their implementation can be very hit-or-miss. Without Elliott’s work, we might still be waiting for Jiangxi Province to say Yes. 

Mr. Zheng, Elliott, Ada and I had some time to chat privately among ourselves. But, not nearly enough. Ada had to rush back to Hong Kong to take care of her twins, and the rest of us had business meetings to attend. For me, though, what most stands out is the deep feeling of friendship, forged by a common purpose to get an exceptionally talented entrepreneur the money he needed to take his business to the next level. 

While the ultimate success at Kehui will rightly belong to Mr. Zheng, all of us benefitted from our work on the financing. Elliott is now recognized as one of the best PE lawyers around. Ada is ready to resume her career at CRCI next week, knowing the Kehui investment is on track for a success as large as she could hope for. And, CFC is also on track to achieving the goal I set for it, of becoming the investment bank most proficient at capital-raising China’s best SME.





Size Matters – Why It’s Important to Build Profits Before an IPO

Qing Dynasty plate -- in blog post of China First Capital

Market capitalization plays a very important part in the success and stability of a Chinese SME’s shares after IPO. In general, the higher the market capitalization, the less volatility, the more liquidity. All are important if the shares are to perform well for investors after IPO.

There is no simple rule for all companies. But, broadly speaking, especially for a successful IPO in the US or Hong Kong, market capitalization at IPO should be at least $250 million. That will require profits, in the previous year, of around $15mn or more, based on the sort of multiples that usually prevail at IPO.

Companies with smaller market capitalizations at IPO often have a number of problems. Many of the larger institutional investors (like banks, insurance companies, asset management companies) are prohibited to buy shares in companies with smaller market capitalizations. This means there are fewer buyers for the shares, and in any market, whether it’s stock market or the market for apples, the more potential buyers you have, the higher the price will likely climb.

Another problem: many stock markets have minimum market capitalizations in order to stay listed on the exchange. So, for example, if a company IPOs on AMEX market in the US with $5mn in last year’s profits, it will probably qualify for AMEX’s minimum market capitalization of $75 million. But, if the shares begin to fall after IPO, the market capitalization will go below the minimum and AMEX will “de-list” the company, and shares will stop trading, or end up on the OTCBB or Pink Sheets. Once this happens, it can be very hard for a company’s share price to ever recover.

In general, the stock markets that accept companies with lower profits and lower market capitalizations, are either stock markets that specialize in small-cap companies (like Hong Kong’s GEM market, or the new second market in Shenzhen), or stock markets with lower liquidity, like OTCBB or London AIM.

Occasionally, there are companies that IPO with relatively low market capitalization of around RMB300,000,000 and then after IPO grow fast enough to qualify to move to a larger stock market, like NASDAQ or NYSE. But, this doesn’t happen often. Most low market capitalization companies stay low market capitalization companies forever.

Another consideration in choosing where to IPO is “lock up” rules. These are the regulations that determine how long company “insiders”, including the SME ownerand his family, must wait before they can sell their shares after IPO. Often, the lock up can be one year or more.

This can lead to a particularly damaging situation. At the IPO, many investment advisors sell their shares on the first day, because they are often not controlled by a lock up and aren’t concerned with the long-term, post-IPO success of the SME client.  They head for the exit at the first opportunity.

These sales send a bad signal to other investors: “if the company’s own investment advisors don’t want to own the shares, why should we?” The closer it gets to this time when the lock up ends, the further the share price falls. This is because other investors anticipate the insiders will sell their shares as soon as it becomes possible to do so.

There are examples of SME bosses who on day of IPO owned shares in their company worth on paper over $50 million, at the IPO price. But, by the time the lock up ends, a year later, those same shares are worth less than $5mn. If it’s a company with a lot market capitalization, there is probably very little liquidity. So, even when the SME bosshas the chance to sell, there are no buyers except for small quantities.

The smaller the market capitalization at IPO, the more risky the lock-in is for the SME boss. It’s one more reason why it’s so important to IPO at the right time. The higher an SME’s profits, the higher the price it gets for its shares at IPO. The more money it raises from the IPO, the easier it is to increase profits after IPO and keep the share price above the IPO level.   This way, even when the lock up ends, the SME boss can personally benefit when he sells his shares.

Of all the reasons to IPO, this one is often overlooked: the SME boss should earn enough from the sale of his shares to diversify his wealth. Usually, an SME boss has all his wealth tied up in his company. That’s not healthy for either the boss or his shareholders. Done right, the SME boss can sell a moderate portion of his shares after lock in, without impacting the share price, and so often for the first time, put a  decent chunk of change in his own bank account.

We give this aspect lot of thought in planning the right time and place for an SME’s IPO. We want our clients’ owners and managers to do well, and have some liquid wealth. Too often up to now, the entrepreneurs who build successful Chinese SMEs do not benefit financially to anything like the extent of the cabal of advisors who push them towards IPO.