PE in China

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

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

 

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

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

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

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

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

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

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

 

 

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

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

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

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

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

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

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

 

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

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

 

 

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.

 

 

An Unfamiliar Chinese Byline — 21st Century Business Herald

21cbh

 

 

I can’t say I ever articulated it as a goal, because it always seemed too far-fetched. But, I did achieve something today I truly value. I had an article published in a leading Chinese newspaper under my own name. Well, not the name my parents gave me, but my Chinese name, 傅成, which is how I’m generally known here. You can click here to see the article. The title, IPO黄金时代一去不返 私募股权行业危机重重, can be translated as “With the Golden Age of IPOs Over,  the Chinese PE Industry is in Crisis”.

It’s an article about problems with unexited PE investments in China, and the block on IPOs for Chinese companies. It appears in the country’s only major national business daily, called 21st Century Business Herald, in English, or 21世纪报纸 in Chinese. Calling it the “Wall Street Journal of China” is a little bit of a disservice, since it enjoys more of a dominant position, both in reputation and in its area of financial reporting, than even the Journal. And I give way to no one in my complete admiration of the WSJ. It is the only newspaper I read and value.

I’ve been an occasional online columnist for 21st Century Business Herald for a couple of years. This may have made them more comfortable when dealing with my rather unusual request, to publish in the daily paper’s news pages under my name an article I submitted to them. This isn’t something Chinese newspapers, especially the major ones, would generally ever do. Media is sensitive in China, extremely well-monitored. I’m just a guy who runs a small advisory firm 1,500 miles from Beijing, and have had no other form of official vetting.

After a day of deliberating, I got word they’d agreed to run the story. I never spoke directly to any of the editors at the newspaper. I wasn’t allowed to. One of the team that manages the online columns acted as middleman.

It was important to me to have the article, as submitted, published, under my name. The article touches on a topic that I think is both important, and little understood — that the block in IPO exits, and the simultaneous cut-off in most new PE funding for private companies in China, is beginning to do real harm to the private sector economy in China. I wanted to make that point, directly and clearly, and not have it be massaged in any way.

I’m a guest in China, and feel extraordinarily privileged to live and work here. There’s nothing in my story critical of government policies, nor should there be. This crisis in China PE industry is largely of its own making.  Yes, the sudden stop of all IPOs does harm to PE investors. But, for years now, China’s PE industry has been overly-reliant on IPO as its one means of exit. Money flooded in and, even at the best of times, only a trickle leaked out through IPO. Now the trickle has been plugged shut. PE firms, their investors and the entrepreneurs they backed are all in serious peril. PEs may lose their LPs money, which would be very unfortunate. But, the real suffering is likely to be borne by the entrepreneurs, who may actually be doing a great job running their business, but now have a desperate unhappy investor inside and so no way to raise the additional capital they need to keep growing. They face a kind of slow asphyxiation.

Another reason I wanted the article to be published under my name was to try to make sure my company got some credit for the work we’ve done over six months to calculate and assess the scale of the problem of unexited deals in China. The article was published this morning. By lunchtime, electronic versions were popping up all over the Chinese internet, on most of the major financial news websites. In almost all cases, these repackaged versions all deleted my name and that of China First Capital. Pretty much par for the course in China. “Journalistic ethics” are two words not frequently paired in China. The pirated articles now discuss the findings of our research without ever mentioning who actually compiled it. If I were a reader, I’d wonder, “why should I believe any of these numbers when the article doesn’t tell me who the source is?” But, I guess Chinese readers aren’t that fussed.

As readers of this blog clearly will have noticed,  me and my company have gotten rather a lot of English-language press attention lately. But, not a single one of those articles, or the whole lump combined, gives me even a fraction of the satisfaction and joy I had this morning holding a Chinese newspaper and finding my article in the middle of page 15.

 

 

 

CFC’s latest research report: 2010 will be record-setting year in China Private Equity

China First Capital 2010 research report, from blog post

 

China’s private equity industry is on track to break all records in 2010 for number of deals, number of successful PE-backed IPOs, capital raised and capital invested. This record-setting performance comes at a time when the PE and VC industries are still locked in a long skid in the US and Europe.

According to my firms’s latest research report, (see front cover above)  the best days are still ahead for China’s PE industry. The Chinese-language report has just been published. It can be downloaded by clicking this link: China First Capital 2010 Report on Private Equity in China

We prepare these research reports primarily for our clients and partners in China. There is no English version.

A few of the takeaway points are:

  • China’s continued strong economic growth is only one factor providing fuel for the growth of  private equity in China. Another key factor that sets China apart and makes it the most dynamic and attractive market for PE investing in the world: the rise of world-class private SME. These Chinese SME are already profitable and market leaders in China’s domestic market. Even more important, they are owned and managed by some of the most talented entrepreneurs in the world. As these SME grow, they need additional capital to expand even faster in the future. Private Equity capital is often the best choice
  • As long as the IPO window stays open for Chinese SME, rates of return of 300%-500% will remain common for private equity investors. It’s the kind of return some US PE firms were able to earn during the good years, but only by using a lot of bank debt on top of smaller amounts of equity. That type of private equity deal, relying on bank leverage, is for the most part prohibited in China
  • 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 original PE firms in China 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

Our goal is to be a thought leader in our industry, as well as providing the highest-quality information and analysis in Chinese for private entrepreneurs and the investors who finance them.