PE China

The Big Churn — How High Partner Turnover Damages China’s Private Equity Industry

China PE partner turnover 

What’s the biggest risk in China private equity investing?  Depends who you’re asking. If you ask LPs, the people who provide all the money that PE firms live off, you will often hear a surprising answer: turnover at PE firms. Nowhere else in the PE and VC world do you find so many firms where partners are feuding, quitting or being thrown off the bus.

A partnership at a PE firm was meant to be a long-term fiduciary commitment. In China, it rarely is. The result is billions of dollars of LP money often gets stranded, and possibly wasted. That’s because when a partner leaves, it often creates a bunch of orphaned investments. The departing partner is generally the only solid link between the PE firm and the investee company. Everyone left behind is harmed — the PE firms, the companies they invest in, and the LPs whose money is trapped inside these deals.

As the CEO one of Asia’s largest and most professional LPs told me recently, “Before committing to a new China fund, we spend more of our time trying to figure out how the partners get along than just about anything else. Will they hang on together through the life of the fund? We know from experience how damaging it is when partners fall out, when key people leave. We know turnover can mean we lose everything we’ve invested. And yet, we still often get stung.

In my nearly-twenty years in and around the PE and VC industry in the US, Europe and Asia, I’ve never seen anything quite like what happens here in China. A quick look through my Outlook contacts reveals that almost half the PE partners I know working in China have changed firms in the last five years. One reason you don’t see this elsewhere is that partners expect to earn carried interest on the deals they’ve made. If they leave, they forgo this.

Carry is a kind of unvested pay. On paper, it’s often quite sizable, and should represent the majority of a PE partner’s total comp, as well a kind of golden handcuff. The only reason for partners to leave is they believe they won’t get any of this money, either because of failed deals or, more commonly, large doubts that the head partner, the person running the firm, will share the rewards from successful deals.

Most China PE firms are partnerships in name only. There is usually one top dog, usually the founder and rainmaker. This person can unilaterally decide who stays, who goes, who gets carry and who gets a lump of coal. Top Dog tends to treat partners like overpaid, somewhat undeserving hired hands.

So, why have partners at all? Often it’s because LPs insist on it, that they want PE and VC firms in China to be structured like those elsewhere. The business card says “Partner” but the attitude, expectations and level of commitment say “Employee”.

Senior staff (VPs, Managing Directors) also frequently depart. In the US, you don’t often see that much, since these are the people in line to become partners, which is meant to be the crowning achievement of a long successful career in the trenches. They leave because they don’t believe they’ll be promoted, or if they are, that they’ll see any real change in their current status as wage-earners.

At a party celebrating a recent IPO of a PE-backed Chinese company, I ran into the PE guy who led the original investment, did all the heavy lifting. He had since left and joined another firm. He laughed when I asked why he would leave before the IPO, with his old firm certain to earn a big profit on his deal. “I don’t know who will get the carry, but I was sure it wouldn’t include me,” he explained.

Partners jump ship most often because someone is offering a higher salary, a higher guaranteed amount of pay. Their new firm will usually also offer them carry. Both sides will negotiate fiercely over the specific terms, what percent with what hurdle rate. And yet, more often than not, it seems to be a charade.

From day one, the new partners may already thinking about their next career move, how to trade up. Emblematic of this: here in China, when PE partners join a new firm, they almost always refer to it as “joining a new platform”. Note the choice of words: platform, not firm.

The LPs — and I speak to quite a lot of them — acknowledge, of course, that there are other big risks in China, that individual investments or even a whole portfolio turns sour. But, this is a risk inherent in all PE investing everywhere. High partner turnover is not.

If you’re interested, you can click here and read the email exchange I had recently with a newly-departed partner at one of China’s better-known VC firms. As I write there, I hate to sound like a scold. I know PE partners also want to earn a good living, and should work where they are happiest and best compensated. But, China’s PE industry serves a deeper economic purpose and holds in trust the assets of both investors and companies. “Looking out for Number One” should not be the only career goal of those working in senior levels in the industry.

 

 

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.

More Trouble for the Big Four Accountants in China: Pushing Prudent Analysis or Propaganda?

This is not a good time for the Big Four accounting firms in China. The SEC has charged them with breaking securities law, while one of the group, Deloitte, is now in serious hot water in the US, facing a shareholder class action in Delaware for aiding a US-listed Chinese company in defrauding US investors. If Deloitte loses, or opts to settle, it could uncork a tidal wave of copycat claims that would do serious, perhaps irreparable damage to the China business of Deloitte, and then also possibly to Ernst & Yong, Price WaterhouseCoopers and KPMG.

The charges against the Big Four all boil down to allegations they were either negligent in fulfilling their statutory duties, or in cahoots with bad guys scheming to defraud US investors. The implication of the SEC charges seems to be the accountants’ willy-nilly pursuit of fees led the Big Four to cut corners, surrender objectivity, and allow their judgment to become corrupted.

Similar doubts can be raised about the quality, credibility and soundness of the judgments the accountants provide in assessing China’s private equity industry. Even as the PE market began to slide into serious trouble last year, the accountants kept talking up the industry. In particular, it’s worth reading the two big and well-publicized reports on China private equity produced by Ernst & Young  and PWC. Both can be downloaded by clicking here. E&Y Report. PWC Report.

Both of these documents were published in late December 2012. All IPO activity for Chinese companies had come to an abrupt halt months earlier, and along with this, China’s PE firms basically went into hibernation, closing off almost all new investment in China. The situation has, if anything, worsened so far in 2013. And yet, to read these reports, my opinion would be that that everything was overall pretty rosy.

Nowhere is it mentioned that a main factor contributing to the collapse of Chinese IPOs is the widespread loss of confidence in the work of accountants. While the PWC report does note the challenge posed by limited exits, it echoes the generally bullish sentiment of the E&Y report. PWC confidently predicts, “We think new deal and exit activity will accelerate strongly from 2Q13 as pricing expectations adjust.” In other words, according to PWC, we’re weeks away now from not just the revival of the comatose China PE industry, it’s going to leap out of bed and begin doing wind-sprints.

Let’s see how things play out.  But, the greater likelihood in my opinion is that 2013 will be the worst year in recent history for China PE. Further out, things look even more dire, as hundreds of PE funds reach the end of their lives still holding tens of billions of dollars in illiquid investments made with LP money.

Why then all the optimism, the boosterism, the cheerleading from the accountants? I have a lot of respect for their professionalism. To me, it seems that their enthusiasm may be more a matter of  wishing, hoping and urging that the PE industry, and the fees that come from it, continue to grow. To crib a line from Warren Buffett’s latest Letter to Shareholders, “wishing makes dreams come true only in Disney movies; it’s poison in business.”

China PE has been good — no, make that, very good — to the Big Four accounting firms. It’s anybody’s guess, but I’d estimate the total fees earned as recently as 2011 by the Big Four for work done for PE firms in China is well above $75mn. This is for audits of existing and potential investments, for other due diligence services and for portfolio valuation.

PE firms are certainly one of the key sources of revenue for the Big Four in China. The Big Four also do work for Chinese corporations, but that market is much more crowded in China, with thousands of local accounting firms also getting their share of corporate audits and tax. The local firms charge about half what the Big Four do. The global PE firms rely almost exclusively on the Big Four to do all their work in China. The PE firms pay top dollar.

The Big Four get paid big money to do audits and projections on many of the deals the bigger PE firms are considering in China.  Very often during due diligence the PE firm opts to abandon a deal. Even when they do, the accounting firms get paid in full. At around $250,000 a pop, the financial DD package on PE deals that never close has become a very lucrative line of business. I’ve also known of cases where the PE firm paid for the audit and projections but then tossed them away after deciding the conclusions were flawed.

Reading the E&Y and PWC reports, it seems to me a primary purpose was marketing, to let the PE industry in China feel good about itself, to reassure distant LPs, and even to encourage China GPs to be a little more bold and active. Nowhere does one read any kind of more sober analysis pointing to the systemic problems in the industry caused by the enormous overhang of unexited deals, expiring fund life, the damage done to IPO markets by false accounting, the billions of dollars in LP money at risk. The reports seem more like propaganda than a prudent assessment.

It’s also puzzling that the accounting companies shared no serious research on the scale of the problem of unexited deals in China. Self-interest, as well as professional credibility,  would seem to dictate it.  Instead, it was my company, which earns fees of precisely zero from PE firms, that made the effort over six months to research and contextualize the problem of unexited deals in China. We had no financial incentive to do this work, but did so because we thought it’s the best way to put the China PE industry on a sounder long-term footing and get PEs to start again making new investments.

It’s not only the accountants that have been gorging on PE firm fees. The big US and UK law firms, management consultants like McKinsey, market research firms and placement agents have also been earning very fat fees and retainers from China’s PE business. My guess is the total amount of LP wealth transferred by China PE firms to professional services firms is above $250mn a year. None of these firms issued serious public warnings to their PE clients about problems bedeviling the industry. McKinsey, which interviews GPs, offered this in the 2012 report I saw on private equity in China, ” As one large GP in China told us, “We’re busier than we have been in the last eight or nine years.”

I can’t help but feel that all these professional services firms have perhaps gotten a little drunk and maybe a little lazy from all the easy money they’ve been earning from China-focused PE funds. No one wants to say anything that might close down the tap on the billions of new LP money coming into China each year, a meaningful slice of which always gets divided among these professional service firms. And so the rather utopian portrayals of China PE keep getting printed and circulated.

It’s similar to the way equity analysts at brokerage houses never seem to have a bad word to say about the companies their firms do business with. Even when an analyst decides the company is a loser, the published research will merely advise to “Hold” or “Accumulate”. In the head-to-head combat between a revenue stream and forthright assessment, the revenue stream always seems to win.

 

 

The End of the Line for Old-Style PE Investing in China

Ming Dynasty flask, from China Private Equity blog post

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

chart1









If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.