Private Equity

China’s SOEs attract PE interest — Private Equity International Magazine

Leave a Comment / March 7, 2014

Private Equity International Magazine

www.peimedia.com

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China’s state-owned enterprise promise big returns for PE investors, as well as a big challenge.

By: Clare Burrows–

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In 2013, private equity investment in China dropped to just $4.5 billion – about 47 percent below the equivalent figure for 2012, according to data from Thomson Reuters. Since China’s dry powder level was estimated at $59 billion at the end of 2012, it’s clear that China’s GPs need to find new ways to deploy the vast amounts of capital raised during better times.–

What seems to be catching the industry’s eye more than ever are the country’s state-owned enterprises:large, government-controlled organisations, many of which are in dire need of restructuring. While state-owned enterprises account directly or indirectly for 60 percent of China’s GDP, according to research by China First Capital, almost 100 percent of institutional capital, especially private equity, has
been invested into China’s privately-owned sector.

However, as the number of traditional opportunities falls, “this may leave investing in SOEs as the best, largest and most promising new area for private equity investment,” Peter Fuhrman, chairman and chief executive at China First Capital suggests.–

And, some industry sources ask: what better target for private equity than these bloated, inefficient giants, which the newly-appointed Chinese government is apparently so keen to reform? SOEs are highly compliant when it comes to tax and accounting laws (a rare phenomenon among China’s privately-owned companies). Better still, they’re a bargain – because China’s State-owned Assets Supervision and Administration Commission (SASAC) regulates their price based on net asset value.–

“If you have a highly profitable SOE that has very low net assets, you can potentially buy it at incredibly low P/E multiples,” Fuhrman says. With one deal China First is advising on, 51 percent of the business is being offered at 2x EBITDA, he adds. China First is currently acting as an investment banker for five of China’s largest SOEs, including China Aerospace, China State Construction, China Huadian, Wuliangye Group and Shandong Energy.

Click here to read full article

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China’s Capital Markets Go From Feast to Famine and Now Back Again, China First Capital New Research Report

Leave a Comment / January 19, 2014

China First Capital 2014 research report cover

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The long dark eclipse is over. The sun is shining again on China’s capital markets and private equity industry. That’s good news in itself, but is also especially important to the overall Chinese economy. For the last two years, investment flows into private sector companies have dropped precipitously, as IPOs disappeared and private equity firms went into hibernation. Rebalancing China’s economy away from exports and government investment will take cash. Lots of it. Expect significant progress this year as China’s private sector raises record capital and China’s state-owned enterprises (SOEs) gradually transform into more competitive, profit-maximizing businesses.

These are some of the conclusions of the most recent Chinese-language research report published by China First Capital. It is titled, “2014民企国企的转型与机遇“, which I’d translate as “2014: A Year of Transformation and Opportunities for China’s Public and Private Sectors”. You can download a copy by clicking here or visiting the Research Reports section of the China First Capital website, (http://www.chinafirstcapital.com/en/research-reports).

We’re not planning an English translation. One reason:  the report is tailored mainly to the 8,000 domestic company bosses as well as Chinese government policy-makers and officials we work with or have met. They have already received a copy. The report has also gotten a fair bit of media coverage over the last week here in China.

Our key message is we expect this year overall business conditions, as well as capital-raising environment,  to be significantly improved compared to the last two years.  We expect the IPO market to stage a significant recovery. Our prediction, over 500 Chinese companies will IPO worldwide during this year, with the majority of these IPOs here in China.

We also investigate the direction of economic and reform policy in China following the Third Plenum, and how it will open new opportunities for SOEs to finance their growth and improve their overall profitability, including through carve-out IPOs and strategic investment. SOEs will become an important new area of investment for PE firms and global strategics.

The SOEs we work with are all convinced of the need to diversify their ownership, and bring in profit-driven experienced institutional investors. For investors, SOE deals offer several clear advantages: scale is larger and valuations are usually lower than in SME deals; SOEs are fully compliant with China’s tax rules, with a single set of books; the time to IPO or other exit should be quicker than in many SME deals.

As financial markets mature in China, we think one unintended consequence will be a drop in activity on China’s recently-established over-the-counter exchange, known as the “New Third Board” (新三板）.  The report offers our reasons why we think this OTC market is a poor, inefficient choice for Chinese businesses looking to raise capital. While the aims of the Third Board are commendable, to open a new fund-raising channel for private sector companies, the reality is that it offers too little liquidity, low valuations and an uncertain path to a full listing on China’s main stock exchanges.

Over the last three years, China has had the highest growth rate and the worst performing stock market among all major economies. In part, the long stock market slide is both necessary and desirable, to bring China’s stock market valuations more in line with those of the US and Hong Kong. But, it also points to a more uncomfortable reality, that China’s listed companies too often become listless ones. Once public, many companies’ profit growth and rates of return go into long-term decline. IPO proceeds are hoarded or misspent. Rarely do managers make it a priority to increase shareholder value.

A small tweak in the IPO listing rules offers some promise of improvement. Beginning this year, a company’s control shareholder, usually the owner or a PE firm, will be locked-in and prevented from selling shares for five years if the share price stays below the original IPO level.

Spare a moment to consider the life of a successful Chinese entrepreneur, both SOE and private sector. In two years, access to capital went from feast to famine. And now maybe back again. An IPO exit went from a reachable goal to an impossibility. And now maybe back again. Meanwhile, markets at home surged while those abroad sputtered. Government reform went from minimal to now ambitious.

2014 is going to be quite a year.

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Private Equity in China 2014: A Dialogue

1 Comment / January 19, 2014

pendant

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PE in China is changing. But, from what and into what?

Over the last week, I had an email discussion with a managing director in China of one of the world’s five largest private equity firms. He wrote to tell me about the fund’s recent change in China strategy, which then triggered an email dialogue on the specific challenges his firm is trying to overcome, and the larger tides that are shaping the private equity industry in China.

I’ll share an edited version here. I’ve taken out the firm’s name and any references that might make it identifiable.

Think it’s easy to be a private equity boss in China, to keep your job and keep your LPs happy? It’s anything but.– – –

PE Firm Managing Director: Peter, I want to share some change in our fund strategy with you and get your opinion on it.

We have optimized our investment strategy for our US$ fund. We will focus more on late-stage companies that can achieve an IPO within 1-2 years and exit/partial exit perhaps 3-4 years or less. Total investment amount is still $30-80M but we prefer larger deal sizes within the range. Since these are high quality companies, we have lowered our criteria and is willing to be more competitive and pay higher valuation and take less % ownership (minimum 4-5% is still OK). We can also buy more old shares and participate in small club deals as long as the minimum investment size is met.

We are also willing to work with high quality listed companies in terms of PIPE/CB. In sum, our strategy should be more flexible and competitive versus before.

Me: Thanks for sending me the summary on the new investment strategy. You could guess I wouldn’t just reply, “sounds fine to me”.

Here’s my view of it, after a day’s thought. If I didn’t know it was from [your firm], or didn’t focus on the larger check size, I’d say the strategy was identical to every RMB PE firm active in China, starting with Jiuding and then moving downward. That by itself is a problem since in my mind, [your firm] operates in a different universe from those guys — you are thoroughly professional, experienced, global, proper fiduciaries. Maybe that’s your opportunity, to be the ” thoroughly professional, experienced, global, proper fiduciary” version of an RMB fund?

Other problem is, unless your firm is even smarter and more well-connected in Zhongnanhai than I think, no one can have any real idea at this point which Chinese companies, other than Alibaba Group,  can gain an IPO in next two years. The English idiom here is “making yourself a hostage to fortune”. In other words, the only way a PE could consistently achieve the goal of “IPO exits within 24 months” is based more on luck than planning and deal execution.

If you asked me, I’d think the way to frame it is you will opportunistically seek early exits, but will focus always on companies where you have confidence EV will increase by +30% YOY over short- and medium-term, in part due to the money and know-how you provide. It’s kind of a hedge, rather than just hoping IPO exits will come roaring back after almost two years with basically zero Chinese IPOs.

The good news for you and for me is that China has so many great companies, great entrepreneurs that all of us can “free ride”, to some extent, on their genius and ability to generate growth and wealth.

PE MD: Thanks for the detailed message and for thinking so hard to help us.

First let me explain why the changes were made. Through extensive recent discussion with limited partners, it appears that a hybrid fund with small early stage, mid-sized growth stage and larger sized late stage or PIPE is not what LPs want as they are in the business of allocating funds to a variety of focused managers rather than just put the money to a single fund doing it all. For example, it could allocate a small portion of its capital to Sequoia or Qiming for early stage and pray they can get a huge return back in five years. For other (major) part of their allocation, they desire some fund which can focus more on IRR increase of Multiple of Capital.

I think this is where we are attempting to position our latest fund. Even though our returns are decent, our previous funds took too long to return distributions and result in lower IRRs.

As you know, my firm has [over $100 billion] AUM. Although the company including the Founder is extremely supportive of our fund, we have to do more to make our fund relevant to the firm financially. Therefore, we need to focus on bigger/latter stage project which can allow us to deploy/harvest capital more quickly than before (3-4 years versus 5-7 years) and building up more AUM per investment professional to reach at least the average for the firm.

Doing many small projects ($10-20 million) has also put a very high administrative burden/cost on our back-office. While the strategy means that we will go in a little bit later stage, taking a smaller-stake sometimes and perhaps pay a higher valuation (since the companies are more expensive as risks are lower closer to liquidity), it doesn’t change our commitment to each investment. In fact, due to the reduced number of investment, we can focus our value creation efforts on each one more. This is very different than the shoot and forget method of Jiuding.

It is true having a smaller stake will reduce our influence and perhaps reduce our ability to persuade the founder to sell in case an IPO is impossible. However, a smaller stake means it is more liquid after IPO and we can be more flexible in selling the stake pre-IPO to another PE. Of course we are not explicitly targeting IPO in 24 month but we are trying to be as late stage as possible while meeting our IRR stand. We do have some idea of what kind of company can IPO sooner based on years of experience. If the markets or regulatory agencies don’t cooperate on the IPO schedule, then we just have to make sure our investments can keep growing without an IPO.

Me: As a strategy, it can’t be faulted. In a nutshell, it’s “Get in, get out, get carry and get new capital allocations from one’s LPs.”

My doubts are down on the practical level. Are there really deals like this in the market? If so, I certainly don’t see them. I’m just one guy feeling the elephant’s tail, and so have nothing like the people, sources that your firm has in China. Maybe there are lots of these kinds of opportunities, well-run Chinese companies with pre-money valuations of +USD$200mn (implying net income of +USD$20mn), and so probably large enough to IPO now, but still looking, somewhat illogically,  to raise outside PE money from a dollar fund at a discount to public markets.  Maybe too there are enough to go around to fill the strategic needs of not just your firm but about every other one active here, including not only the RMB crowd, but all the other big global guys, who also say they want to find ways to write big dollar checks in China and exit these deals within 2-3 years. (This is, after all, the genesis of the craze to throw money into PtP deals in the US, none of which have made anyone any money up to this point.)

Is China deal flow a match for this China strategy? That’s the part I’ll be watching most closely.

My empirical view is that the gap may be growing dangerously ever wider between what China PEs are seeking and what the China market has to offer. This is a country where the best growth capital deals and best risk-adjusted investments are concentrated among entrepreneurial private sector businesses with (sane) valuations below $100mn. In other markets, scale is inversely correlated with risk. In China, it is probably the opposite. Bigger deals here usually have more hair on them than an alpaca.

From our discussions over the years, I know you’re someone who looks at deals through a special, somewhat contrarian prism. Your firm’s new strategy pulls in one direction, while your own inclinations, judgment and experience may perhaps pull you in another.

We’re finishing up now a “What’s ahead in 2014″ Chinese-language report that we’ll distribute to the +6,500 Chinese company bosses, senior management and Chinese government officials in our database.  I’ll send a copy when it’s done. You’ll see we’re basically forecasting 2014 will be a better year to operate and finance a business in China than the last two years. Our view is good Chinese companies should seize the moment, and try to outrun and outgun their competitors.  Your role: supply the fuel, supply the ammo.

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IPO rules overhauled for PE and VC firms — China Daily

Leave a Comment / May 1, 2014

China Daily article

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Shanghai stock exchange trading floor

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Friday, January 3, 2014

Private equity and venture capital firms will have to conduct their business differently in China in 2014, after regulators overhauled initial public offering rules.

Chinese PE and VC companies used to evaluate the companies by the standards of the China Securities Regulatory Commission for quicker IPOs, but now the market will play a more important role, said Peter Fuhrman, chairman, founder and chief executive officer at China First Capital.

“Under the new IPO system, the share pricing of an IPO company is decided by its strength and competitiveness, so investors will choose companies with real potential to invest in and provide them with the resources of strategy, management and market development to make their own return the best,” said Fuhrman *.

Private equity and venture capital firms will not find it easy to earn money any more after the new share-listing reform plan is carried out, because even if the companies they invested in get listed, they will still face the risk of losses, said Jin Haitao, chairman of leading Chinese equity investment firm Shenzhen Capital Group Co Ltd.

Jin said PE and VC institutions should cultivate real investment capabilities including those in value-discovery and negotiating. Pre-IPO deals cannot be guaranteed to earn money any more.

A total of 83 Chinese companies completed the examination and received approval from the China Securities Regulatory Commission. About 50 are expected to have finished all IPO procedures and be listed before the end of January. More than 760 companies are in line for approval. It will take about a year to audit all the applications.

In the IPO reform plan announced at the end of November, information disclosure has become more important and the China Securities Regulatory Commission will only be responsible for examining applicants’ qualifications, leaving investors and the markets to make their own judgments about a company’s value and the risks of buying its shares.

More and more Chinese companies applying for IPOs asked for cooperation with multinational accounting institutions, according to Hoffman Cheong, an assurance leader at Ernst & Young China North Region.

Cheong said the information disclosed can be different after the IPO reform plan is carried out.

According to the IPO reform plan, so long as an issuer’s prospectus is received by the commission, it will be released on the commission’s website. The company should buy back shares if there is a false statement or major omission. Also it should compensate investors if they lose money in certain situations.

http://www.chinadailyasia.com/business/2014-01/03/content_15109395.html

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(* Note: I never spoke to the reporter. As far as I can tell, the quote was translated into English, rather clumsily, from a Chinese-language commentary of mine published recently in a Chinese business publication. If asked, I would have said that companies need to choose PE investors carefully, and vice versa.)–

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

Leave a Comment / December 12, 2013

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.–

 

 

Private Equity Secondaries in China — PEI Magazine Whitepaper

Leave a Comment / December 5, 2014

–Secondaries

 

 

PEI Secondaries Cover–

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Private equity dealflow continues to stall in China – but so far it hasn’t yet prompted the hoped-for explosion in secondary market activity

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Secondaries specialists have been busy in Asia lately. While firms such as LGT Capital Partners and Paul Capital have been doing secondaries deals from Hong Kong since 2007, in the last 18 months other firms such as Greenpark Capital, AlpInvest Partners and Lexington Partners have all been enhancing their Asia presence.

So far, secondary market activity in Asia has been more of a gradual flow than a wave of deals. But the changing macroeconomic conditions are increasing pressure on GPs – and that could result in more opportunities, particularly in China. Asia’s largest and most attractive market is losing some of its shine, thanks to a sustained slowdown in annual GDP growth and a frozen IPO market that has left GPs holding assets that they need to exit.

“If you could do [secondaries] at this moment – wow,” says Peter Fuhrman, chairman and chief executive of China First Capital. “In this market, some LPs could sell out for 10 cents on the dollar. For LP secondary buyers, it is nirvana: a distressed exit market, portfolios with solid growing businesses inside of them, and a group of somewhat distressed LPs. A lot of these LPs, even bigger ones who have their money in China, have lost faith.”

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Click to Read Full Article
Click To Read Full PEI Whitepaper Report on Private Equity Secondaries

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Chinese IPOs Try to Make a Comeback in US — New York Times

Leave a Comment / June 24, 2016

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I.P.O./Offerings

Chinese I.P.O.’s Try to Make a Comeback in U.S.

BY NEIL GOUGH

HONG KONG — Chinese companies are trying to leap back into the United States stock markets.

The return, still in its early days and involving just a handful of companies, comes after several years of accounting scandals that pummeled their share prices and prompted scores of companies to delist from markets in the United States.

But the spate of recent activity suggests investors may be warming once more to Chinese companies that seek initial public offerings in the United States.

Qunar Cayman Islands, a popular travel website owned by Baidu, China’s leading search engine company, began trading on Nasdaq on Friday and nearly doubled in price. On Thursday, shares in 58.com, a Chinese classified ad website operator that is often compared to Craigslist, surged 42 percent on the first trading day in New York after its $187 million public offering.

The question now — for both American investors and the companies from China waiting in the wings to raise money from them — is whether these recent debuts are an anomaly or have truly managed to unfreeze a market that was once a top destination for Chinese companies seeking to list overseas.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm based in Shenzhen, China, said that for both sides, the recent signs of a détente between American investors and Chinese companies is “a matter of selectively hoping history repeats itself.”

“Not the recent history of Chinese companies dogged by allegations, and some evidence, of accounting fraud and other suspect practices,” he added. “Instead, the current group is looking back farther in history, to a time when some Chinese Internet companies with business models derived, borrowed or pilfered from successful U.S. companies were able to go public in the U.S. to great acclaim.”

That initial wave of Chinese technology listings began in 2000 with the I.P.O. of Sina.com and later featured companies like Baidu, which has been described as China’s answer to Google. In total, more than 200 companies from China achieved listings on American markets, raising billions of dollars through traditional public offerings or reverse takeovers.

But beginning about 2010, short-sellers and regulators started exposing what grew into a flurry of accounting scandals at Chinese companies with overseas listings. In some cases, such accusations have led to the filing of fraud charges by regulators or to the dissolution of the companies. Prominent examples include the Toronto-listed Sino-Forest Corporation, which filed for bankruptcy last year after Muddy Waters Research placed a bet against the company’s shares in 2011 and accused it of being a “multibillion-dollar Ponzi scheme.”

Concerns about companies based in China were reinforced in December when the United States Securities and Exchange Commission accused the Chinese affiliates of five big accounting firms of violating securities laws, contending that they had failed to produce documents from their audits of several China-based companies under investigation for fraud.

In response, American demand for new share offerings by Chinese companies evaporated, and investors dumped shares in Chinese companies across the board. It became so bad that the tide of listings reversed direction: Delistings by Chinese companies from American markets have outnumbered public offerings for the last two years.

Despite the renewed activity, it is too early to say whether Chinese stocks are back in favor. The listing by 58.com was only the fourth Chinese public offering in the United States this year, according to Thomson Reuters data. LightInTheBox, an online retailer, raised $90.7 million in a June listing but is trading slightly below its offering price. China Commercial Credit, a microlender, has risen 50 percent since it raised $8.9 million in August. And shares in the Montage Technology Group, based in Shanghai, have risen 41 percent since it raised $80.2 million in late September.

Still, this year’s activity is already an improvement from 2012, when only two such deals took place, according to figures from Thomson Reuters. Last month, two more Chinese companies — 500.com, an online lottery agent, and Sungy Mobile, an app developer — submitted initial filings for American share sales.

But the broader concerns related to Chinese companies have not gone away. In May, financial regulators in the United States and China signed a memorandum of understanding that could pave the way to increased American oversight of accounting practices at Chinese companies. But the S.E.C.’s case against the Chinese affiliates of the five big accounting firms remains in court.

The corporate structure of many Chinese companies is another unresolved area of concern. Because foreign companies and shareholders cannot own Internet companies in China, both 58.com and Qunar rely on a complex series of management and profit control agreements called variable interest entities. Whether such arrangements will stand up in court has been a cause for concern among foreign investors in Chinese companies.

And short-sellers continue to single out companies from China, often with great success.

In a report last month, Muddy Waters took aim at NQ Mobile, an online security company based in Beijing and listed in New York, accusing it of being “a massive fraud” and contending that 72 percent of its revenue from the security business in China last year was “fictitious.”

NQ Mobile has rejected the accusations, saying that the report contained “numerous errors of facts, misleading speculations and malicious interpretations of events.” The company’s shares have fallen 37 percent since the report was published.

(http://dealbook.nytimes.com/2013/11/01/chinese-i-p-o-s-attempt-a-comeback-in-u-s/?_r=1)
 
Download PDF version.
 

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Hong Kong IPO Today for China First Capital Client Hydoo

Leave a Comment / October 31, 2013

Hydoo Prospectus

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Welcome good news today from Hong Kong’s capital markets. The Chinese commercial real estate developer Hydoo (Chinese name 毅德) successfully IPOs on the Hong Kong Stock Exchange, raising over USD$200mn in new capital. With IPO channels for Chinese companies mainly blockaded, it’s especially welcome to see a Chinese private sector company raising so much from the stock market.  In this case, the delight is greater because Hydoo is a client of China First Capital. We acted as Hydoo’s investment bankers raising USD$80mn from Chinese private equity firm Hony Capital.  Hony’s 2011 investment, based on today’s IPO price, is now worth USD$150mn.

In addition to Hony, China’s giant financial services group Ping An also invested before IPO.  In total, Hydoo raised USD$140mn (Rmb 860mn) of institutional capital before IPO. Over 60% of the IPO shares (worth over $120mn) were sold by underwriters ahead of time to so-called “cornerstone investors“, including two large Chinese SOEs, Huarong and China Taiping Insurance, as well as retailer Suning (in which Hony owns a share).

I’m happy for Hony and the other investors, but happier still for Hydoo founders, particularly its chairman, Wang Zaixing, known to friends and family  as “Laowu”, literally “Venerable Fifth”. He is the fifth-born of ten children all of whom played a part in building Hydoo. The family is originally from Chaozhou in Guangdong, and speak the distinctive Chaozhou dialect. But, they ended up after 1949 in Ganzhou, Jiangxi Province.

The business Laowu started 18 years ago is now worth over $1 billion. The first time I met him, I told Laowu my goal as his investment banker, and my emphatic expectation,  was that his company would be worth at least that much at the time of its IPO. Another priority of mine was that he and his family members would still hold majority control after IPO.  That too has been achieved.  They hold almost 60% of the now publicly-traded business.

For me, Laowu personifies in many ways the large economic changes China has undergone in the last 30 years. He started life as a long-distance truck driver and from that humble start saw and grasped an opportunity to build wholesale trading centers for the emerging army of small businesspeople in China.

I first met Laowu and his company in 2009. The business was then called Haode (豪德). It was then still an old-school Chinese family business. There was no corporate structure in the traditional sense. Laowu and his brothers, sister and nephews would pair up, or act independently, to do individual large wholesale trading centers around China. When I met them, the family had already done 19 such projects. All had done very well. At the time, I’d never met a Chinese private company as profitable over as many years as Haode.

Over the last three years, the company has been transformed into a more professional enterprise. Hydoo provides a useful excellent template for how a Chinese family-owned business can make this transition to a publicly-traded company. Part of that process was splitting up the family’s existing business between a group that would follow Laowu and become shareholders of Hydoo, and five other siblings who chose not to participate, but remain active in some cases building their own wholesale trading centers.

As the IPO prospectus puts it,  this division was “a complex, delicate process involving the allocation of assets or interests in the existing businesses among a group of closely connected family members, who decided to split up into two independent groups with diverging goals going forward. Under the special circumstances, no written agreements were entered into in respect of the Family Allocation and no valuation appraised by independent valuers was undertaken when negotiating the Family Allocation. Instead, the Wang Family Group placed their focus on more subjective, personal factors.”

Me and my firm played a small part by advising Laowu and his siblings on the pros and cons of being part of a company planning for an IPO. But, as you’d expect, most of this was done within the private confines of a large, closely-knit family.  Along the way, though, I gained a deeper appreciation of the unique ways Chaozhou people do business.

Chaozhou natives are rightly famous both in China and throughout much of Southeast Asia for their business acumen. They are often described by other Chinese as “the Jews of China”.  As a Jew in China, I tend to think the description flatters my people. Chaozhou people seem to have an instinctive and unsurpassed talent for making money and entrepreneurship. Look around the world at the most successful Chinese business people, including the leading business families in Thailand, Indonesia, Singapore, Malaysia and Hong Kong, and a large percentage, including Asia’s richest magnate, Li Ka-shing, Thailand’s richest businessman Dhanin Chearavanont  and Indonesia’s top tycoon, Mochtar Riady, are either from Chaozhou or are descended from people who immigrated from there.

As this suggests, Chaozhou people are able and willing to uproot themselves and chase opportunities. Laowu didn’t leave China, but in building Hydoo, he did venture far afield from where he and his family were raised. He saw very early and profited richly from an economic shift within China that few others noticed 15 years ago. At the time, much of China’s economic growth was centered in southern China, and large coastal cities like Shanghai, Shenzhen, Xiamen. Laowu looked inland, especially in Shandong Province, one thousand miles north of Chaozhou.

As the economies of Shanghai and big southern coastal cities began to cool, inland areas, led by Shandong, began to boom. Shandong’s GDP growth, over the last ten years, has been among the highest of any part of China. Shandong is a huge market to itself (population 95mn) as well as a vital crossroads for commerce between north and south, east and west in China. Laowu built large wholesale parks to accommodate thousands of small traders, creating new clusters of small-scale commerce and entrepreneurship.

When you visit one of these centers, you get the impression that half of Shandong’s gdp is going in and out the doors. It’s crowded and vibrant. Even the smallest traders own their own small shop inside the Hydoo centers. That’s Hydoo’s model: they build the buildings, and as they do, sell off most of the units to thousands of individual small traders. Hydoo helps them get mortgages and often acts as guarantor on the loans. This lets thousands of small businesspeople become property-owners. As the Hydoo centers thrive (and they all do, as far as I know) the value of the real estate rises.

I know of no other businessman in China that has done as much as Laowu to build wealth and provide an entrepreneurial hub for such a large number of people in China. Hydoo is now spreading across more areas of China. It’s is building huge new wholesale parks in Sichuan, Hunan, Guangxi, Gansu.

I see Laowu infrequently these days. But, I’m as impressed now as I was when I first met him by his accomplishments. He and his family founded a business back when China was a different and less developed place. They stuck with it, kept reinvesting and now, through today’s IPO,  own shares worth more money than I can imagine. But, more important for me is that they still own the business, still own the majority and so answer to no one else. As an entrepreneur who helped create and sustain so many other entrepreneurs, Laowu deserves nothing less.

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Private Sector Capital for China’s SOEs — China First Capital Press Release

Leave a Comment / July 16, 2014

China First Capital press release

Hong Kong, Shenzhen, China:  China First Capital, an international investment bank and advisory firm focused on China, today announces it has received a pioneering mandate from a large Chinese State-Owned Enterprise (“SOE”) holding company to manage a process to revitalize and privatize part of the group by bringing in private capital.

“The investment environment for SOE deals in China is undergoing a significant and exciting change,” commented China First Capital chairman and founder Peter Fuhrman. “We are proud to play a role as investment bankers and advisors in this change, by working with some of China’s SOEs to complete restructuring of unquoted subsidiaries and then raise private sector capital to finance their future expansion. We see these SOE investment deals as the next significant opportunity for institutional investors eager to allocate more capital to China.”

By some estimates, China’s SOEs account for over 60% of total Chinese GDP. Yet, up to now, they have only rarely done private placements or spinoffs to access institutional investment, including from private equity firms. But, according to China First Capital’s internal research, an increasing number of China’s SOEs will face a funding gap in coming years. SOEs, in most cases, have ambitious expansion plans fully supported by the Chinese government. Yet, the SOEs are restricted in their ability to raise large amounts of new bank loans. They are under pressure from Chinese government to maintain or lower their debt-to-equity ratios.

More…

Neue Zurcher Zeitung Interview

 

Investors Vs. Asset Managers: A Dysfunction at the Heart of China Private Equity

1 Comment / September 12, 2013

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Assuming the same level of risk, would you rather make $100 from investing $10 or from investing $50? Easy, right? Who wouldn’t choose to make ten times your money, rather than just double it? There is one group I know. Private equity firms active in China. At least some of them. They care more about the amount they can invest in a deal than the profits they stand to make.

The illogic at work here is the direct result of some particular, not very appealing characteristics,  of the PE industry in China. PE firms lately have more confidence in their ability to raise money than to invest it profitably by achieving a timely exit. To raise money, though, a PE firm needs first to spend most of what it already has. Result: a rush to get money out the door and parked in deals.

In industry parlance, “check size” is often more important than potential risk-adjusted returns.This is one reason for the recent rash of “take private” PtP deals of Chinese companies quoted in the US. (See previous articles, including here, here, here. ) The transactions seem to me ill-considered. PEs have invested billions of dollars in such deals but there is not a single successful example they can point to of such PtP deals done in the US making money for investors. This must be a PE industry first — so much LP money put at risk against an investment idea that is totally unproved.

Who’s most harmed from focus on “check size” over deal quality and prospective returns? Of course it’s the LPs whose money is put into these deals. They want and need high returns, not bigger deals done using their money to aid PE firms’ future fund-raising.

But, Chinese entrepreneurs also suffer in this environment, because many PE firms now simply won’t look at deals where they can’t invest at least $25mn for around 25% of the company. There are few deals out there in that size range, meaning deserving entrepreneurs can’t find investors.

The big picture here: PE in China has become more and more a business dominated by asset managers not investors. How to tell the two apart? An asset manager enjoys the comfort and certainty of making a steady 2% a year managing other people’s money. The more money they raise, the more money they keep. Good markets or bad, the money keeps rolling in.

An investor, on the other hand, is a whole different animal. They share some DNA with the entrepreneurs they back. They love the sport of finding and evaluating deals, spotting where big money can be made, putting money at risk. When it works, they make big sums for their investors, and keep a nice chunk themselves.

Needless to say, LPs give money to PE firms in hopes they have chosen investors not asset managers. PE firms know this, of course, and tailor their money-raising pitch accordingly. They stress their deal-making prowess, not the fact that over the life of a typical 10-year fund, an LP will start with a 20% cumulative loss, because of the typical annual management fee deductions.

In China, it used to be fairly easy to make money in PE. But, over the last three years, returns began to head south. More recently,  over the last 18 months, the performance has mainly been dismal, with few successful deals exiting with big profits. It’s getting harder and harder for LPs to make money in China PE, after those accumulated management fees have been deducted.

But, there’s a time lag — as well as an information asymmetry — at work here. While recent performance has been, on the whole, lousy, there’s still appetite among LPs to allocate more money to China. A big reason is that China’s economy, and capital markets, are both the second-biggest in the world. Most LPs are seriously underweight China and want to change that.

And so we arrive at the current paradoxical situation, where it’s still comparatively easier to collect money to invest in China than to make money deploying it. Now, of course, PE firms can only succeed in raising capital if they can point to some successful past deals. Here too there’s an information asymmetry at work. Many PE firms did well from 2005-2010, and so their fund-raising documents emphasize deals done during this era. But, the game has changed out of all recognition since then.

Few, if any, PE firms have shown they can continue to earn investors good money when markets become less accommodating. It’s no longer possible to play the game of valuation arbitrage, of investing in China deals at single digit p/e multiples, and exiting them soon after at 5-10 times higher multiples through an IPO.

Earning a profit on an investment takes preparation, luck and time. Making money by convincing people to pay you a fee to manage theirs, by contrast, is a much simpler proposition, as well as a no-lose one.

And so the gulf widens between the objectives of PE firms and the fiduciary responsibilities and performance goals of the institutions whose money they manage.

This can be a problem everywhere in the PE and VC industry, as well as more broadly wherever people get paid to manage assets owned by someone else. (See principal-agent dilemma.)   But, it’s probably especially pernicious in China PE.

The industry is staffed mainly be ex-investment bankers, who by background and temperament understand more about fee-based, than performance-based, compensation. Few have a background of actually managing a company, investing its capital to produce a return. Without this first-hand understanding, it’s far harder as an investor to plot how to make an operating business more valuable. The result: PE firms in China will often opt for an easier path: making money by raising money from, and managing for,  other financial professionals.

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Why China PE will rise again — Interview in China Law & Practice Annual Review 2013

2 Comments / March 11, 2014

—CLP

 

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Peter Fuhrman, chairman of China First Capital, talks to David Tring about his company’s disciplined focus, what the IPO freeze means for PE investors and how a ruling from a court in China has removed a layer of safety for PE firms

What is China First Capital?

China First Capital is a China-focused international bank and advisory firm. I am its chairman and founder. Establishing, and now running, China First Capital is the fulfilment of a deeply-held ambition nurtured for over 30 years. I first came to China in 1981, as part of a first intake of American graduate students in China. I left China after school and then built a career in the US and Europe. But, throughout, I never lost sight of the goal to return to China and start a business that would contribute meaningfully and positively to the country’s revival and prosperity.

China First Capital is small by investment banking industry standards. Our transaction volume over the preceding twelve months was around $250 million. But, we aim to punch above our weight. China First Capital’s geographical reach and client mandates are across all regions of China, with exceptional proprietary deal flow. We have significant domain expertise in most major industries in China’s private and public sector, structuring transactions for a diversified group of companies and financial sponsors to help them grow and globalise. We seek to be a knowledge-driven company, committed to the long-term economic prosperity of Chinese business and society, backed by proprietary research (in both Chinese and English), that is generally unmatched by other boutique investment banks or advisory firms active in China.

What have been some of the legislative changes to the PE sector this year that are affecting you?

The recent policy and legislative changes are mainly no more than tweaks. There has been some sparring within China over which regulator would oversee private equity. But, overall, the PE industry in China is both lightly and effectively regulated. A key change, however, occurred through the legal system within China, when a court in Western China invalidated the put clause of a PE deal done within China, ruling that the PE firm involved had ignored China’s securities laws in crafting this escape mechanism for their investment.  While the court ruled on only a single example, the logic applied in this case seems to me, and many others, to be both persuasive and potentially broad-reaching. For PE firms that traditionally added this put clause to all contracts they signed to invest in Chinese companies, and came to rely on it as a way to compel the company to buy them out after a number of years if no IPO took place, there is now real doubt about whether a put clause is worth the paper it’s printed on. Simply put, for PE firms, it means their life-raft here in China has perhaps sprung a leak.

What are some of the hottest sectors in China that are attracting PE investors?

At the moment, with IPOs suspended within China and Chinese private companies decidedly unwelcome in the capital markets that once embraced them by the truckload – the US and Hong Kong – there are no hot sectors for PE investment in China now. The PE industry in China, once high-flying, is now decidedly grounded and covered in tarpaulin. What is perhaps most unfortunate about this is that what we are seeing mainly is a crisis within China’s PE industry, not within the ranks of China’s very dynamic private entrepreneurial economy. In other words, while financing has all but dried up, China’s private companies continue, in many cases, to excel and outperform those everywhere else in the world. The PE firms made a fundamental miscalculation by pouring money into too many deals where their only method of exit, of getting their money back with a profit, was through an IPO. By our count, there are now over 7,500 PE-invested deals in China all awaiting exit, at a time when few, if any exits are occurring. Since PE firms themselves have a finite life in almost all cases, this means over $100bn in capital is now stuck inside deals with no high-probability way to exit before the PE funds themselves reach their planned expiry. The PE industry has never seen anything quite like what is happening now in China.

What is a typical day like for you at China First Capital?

We are lucky to work for an outstanding group of companies, mainly all Chinese domestic. Indeed, I am the only non-Chinese thing about the business. I am in China doing absolutely what I love doing. There are no aspects of my working day that I find tedious or unpleasant. Even at my busiest, I am aware I am at most a few hours away from what the next in an endless series of totally delicious Chinese meals. That alone has a levitating effect on my spirit. But, the real source of pleasure and purpose is in befriending and working beside entrepreneurs who are infinitely more skilled, more driven and wiser to the ways of the world and more successful than I ever could hope to be.

We are quite busy now working for one of China’s largest SOEs. It’s something of a departure for us, since most of our work is with private sector companies. But, this is a fascinating transaction that provides me with a quite privileged insider’s view of the way a large state-owned business operates here in China, the additional layers of decision-making and the unique environment that places far greater onus on increasing revenues than profits.

What do you find are some of the major issues or concerns for foreign PE clients when doing deals in China?

All investors looking to make money in China, whether on the stock market or through private equity and venture capital,  must confront the same huge uncertainty – not that China itself will stop its remarkable economic transformation and stop growing at levels that leave the rest of the developed world behind in the dust. This growth I believe will continue for at least the next 20 years. The big unknown has to do with the actual situation inside the Chinese company you are buying into. Can the financial statements and Big Four audits be relied on? Are the actual profits what the company asserts them to be? How great is the risk that investors’ money will disappear down some unseen rat hole?

Some frightening stories have come to light in the last two years. How widespread is the problem of accounting fraud in China? Part of the problem really is just the law of big numbers. With a population almost triple that of the US and Western Europe combined, China has a lot of everything, including both remarkable businesses run by individuals who are the entrepreneurial equal of Henry Ford and Steve Jobs, and well as some shady operators.

What is your outlook for China’s PE sector in the coming 12 months?

I believe the current crisis will abate, and stock markets will once again welcome Chinese private sector companies to do IPOs. The IPOs will be far fewer in number than in 2010, but still the revival of IPO exits will also thaw the current deep-freeze that has shut down most PE activity across China. PE firms will again start to invest, and put a dent in the $30 billion or more in capital they have raised to invest in China but have left untouched. The PE industry in China, since its founding a little more than a decade ago, grew enormously large but never really matured. There are now too many PE firms. By some count, the number exceeds 1,000, including hundreds of Renminbi PE firms started and run by people with no real experience investing in private companies. Their future appears dire. At the same time, the global PE firms that bestride the industry, including Carlyle, Blackstone, TPG, KKR, have yet to fully establish they can operate as efficiently and profitably in China as they do in Europe and the US.

While the China PE industry struggles to recover from many self-inflicted wounds, China’s private sector companies will continue to find and exploit huge opportunities for growth and profit in China, as the nation’s one billion consumers grow ever-richer and ever more demanding.

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Private Equity in China 2013: the Opportunity & The Crisis — China First Capital Research Report

2 Comments / June 29, 2013

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Making money from private equity in China has become as challenging as “trying to catch a fish in a tree“*. The IPO exit channel is basically shut. Fundraising has never been harder. One hundred billion dollars in capital is locked up inside unexited deals. LPs are getting very anxious. Private companies are suffocating from a lack of new equity financing. PE firms are splintering as partners depart the many struggling firms.

Looking beyond today’s rather grim situation, there are some points of light still shining bright. China remains the world’s fastest-growing major economy with the world’s most enterprising private sector. Entrepreneurship remains China’s most powerful, as well as inexhaustible, natural resource. So long as these two factors remain present, as I’m sure they will for decades to come, China will remain an attractive place to put money to work. But, where? With whom?

China First Capital has published its latest survey covering China PE, M&A and capital markets. The report is titled, ” Private Equity in China 2013 — The Opportunity & The Crisis“. It can be downloaded by clicking here.

During the last year, as China PE first stumbled, then fell into a deep pit, a lot of people I talk to in the industry suggested this was a positive development, that the formation of funds and fundraising had both gotten out of hand. Usually, the PE firm partners saying this quickly added, “but this doesn’t apply to us, of course”.  In other words, as the American saying has it,  “Don’t blame you. Don’t blame me. Blame the guy behind the tree.” It’s all somebody else’s fault.

That’s an interesting take. But, not one that holds up to a lot of scrutiny. The reality is that everyone in the business of financing Chinese companies, myself included, got a little drunk and disorderly. China, in business terms, is the world’s largest punchbowl filled with the world’s most intoxicating liquor. Too many good companies. Too much money to be made. Too much money to be had.

It was ever thus. From the first time outside investors and dealmakers got a look at China, they all went a little berserk with excitement.  This was as true of Marco Polo in the 14th century as British opium houses in the 19th century and American endowments and pension funds in the last decade. The scale of the place,  of the market,  is just so stupefying.

The curse of all China investing is counting one’s fortune before it’s made.  In the latter half of the 19th century, for example, European steel mills dreamed of the profits to be made from getting Chinese to switch from chopsticks to forks and knives.

PE firms did a lot of similar fantasizing. Pour money in at eight times earnings, and pull it out a few years later after an IPO at eighty.   All the spreadsheets, all the models, all the market research and top-down analytics — in the end, it all came back to this intoxicating formula. Put a pile of chips on number 11 then spin the roulette wheel. There were a few winners in China PE, a few deals that hit the jackpot. But, the odds in roulette, at 36-to-one, turned out to be much more favorable.

For every PE deal that made a huge return, there are 150 that either went bust or now sit in this near-endless queue of unexited deals, with scant likelihood of an IPO before the PE fund’s life expires.

The China First Capital research report, rather than making any predictions on when, for example, IPOs will resume and at what sort of valuation,  delves more deeply into some more fundamental issues. These include ideas on how best to resolve the “principal-agent dilemma”, and the growing risks to China’s economic reform and rebalancing strategy caused by the drying up of IPO and PE financing of private sector companies.

We hope our judgments have merit. But, above all, they are independent. Unconflicted. That seems more and more like a rarity in our profession.

 

* A prize to the first person who successfully identifies the source of this quote. A hint: it was said by a former, often-maligned ruler of China.

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New capital drought threatens growth in China — China Daily

Leave a Comment / June 24, 2016

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Continued lack of IPO proceeds and private equity input will damage China’s economic reform

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By Peter Fuhrman

China’s private sector is experiencing an unprecedented shortage of new investment capital. The two predominant flows of growth capital for China’s private sector – initial public offering proceeds and new investments by more than 1,000 private equity firms active in China – have both dried up.

As recently as 2011, IPOs and PE firms pumped $20 billion (15 billion euros) to $30 billion a year of new capital into private companies in China. In the past nine months, that figure has dropped to almost zero.

Even when IPOs cautiously resume, the flow of capital to private companies will likely remain at levels far below recent years. If so, it will quite possibly damage the plans of the Chinese government, as well as the hopes of many of its citizens, to “rebalance” the Chinese economy away from reliance on state-owned enterprises and toward one oriented more toward meeting the needs and fulfilling the hopes of the country’s 1.3 billion people.

All companies need capital to grow. This is especially true among China’s private sector businesses. They operate in a particularly fast-growing market, where both opportunities and competitors are plentiful. Private sector companies are also the main source of new jobs in China, and an increasingly vital contributor to overall GDP growth.

Over the past decade, these Chinese companies became perhaps the world’s hottest investment targets. China’s PE industry, both dollar and yuan, grew from basically zero to become the second-largest in the world. PE firms raised more than $200 billion to invest in China and then put money in more than 10,000 Chinese companies. At the same time, Hong Kong, New York and China each year vied for the title of world’s largest IPO market, with most of the deals being new offerings by Chinese companies.

New capital drought threatens growth

China still has more of the world’s best, most talented private sector entrepreneurs than any country. Investing in their companies remains one of the best ways to make money anywhere. But, for the moment, only a few are willing to try.

This problem is at its core a market failure caused by the loss of investor confidence inside and outside China in the true financial situation of its private sector companies. Questions are raised about financial fraud inside Chinese private companies. Though the concerns are real, the problems are of limited scope, often technical, and the market’s reaction has been severely overblown.

The accounting issues first arose in the US, with the uncovering of several cases of phony accounts among Chinese private companies quoted there. The contagion of doubt spread first to other Chinese private sector companies already listed or seeking to IPO in the US, then to those waiting for an IPO in Hong Kong, until recently the largest market in the world for new IPOs.

Finally, from the summer of 2012, the stock markets on the Chinese mainland began shutting down new IPOs. When the IPOs stopped, most PE firms stopped investing.

The PE firms are sitting on more than $40 billion in capital that they say is for investing in China’s fast-growing private sector companies. But that money is now idle in bank accounts, not going to help good companies become better.

The longer China’s private sector goes without access to major new capital, the more unbalanced the Chinese economy may become.

I first came to China in 1981. During the past 32 years, China’s private sector has gone from non-existent to producing more than half of the country’s GDP. The private sector produces just about everything ordinary Chinese rely on to better the quality of their lives – not just more and better-paying jobs, but also new housing, shops, clothing, restaurants, tutoring for their children and a vibrant Internet and e-commerce industry.

As these private companies have gone from small mom-and-pops to some giant businesses, including virtually all China’s leading domestic consumer brands, the dependence on IPO proceeds and PE money has become almost absolute. So, the dramatic slowdown in the flow of capital to private companies will have an impact on these businesses, their customers and ultimately China’s GDP.

At this point, the only outside financing available for Chinese private companies are bank loans, which remain difficult and costly to arrange. The banking system is, however, fixated on lending to state-owned enterprises. That leaves only the so-called “shadow banking system”, where loan sharks provide short-term money at interest rates of at least 25 percent per year. But, recently, even many loan sharks have fled the marketplace.

The Chinese government has created a set of policies that allowed the private sector to flourish. It also encouraged the flow of capital from the PE industry and IPOs. The plan had been to rely on the private economy to shoulder much of the burden of restructuring the Chinese economy away from SOEs and exports, while creating new jobs and supplying the goods consumers most want.

But that planned rebalancing cannot happen without money, without new capital for the private sector. Instead of a rebalance, China’s economy is possibly headed toward a more lopsided reliance on the state sector and big-ticket government spending projects.

(The author is founder and chairman of China First Capital, a China-focused investment banking and advisory firm. The views do not necessarily reflect those of China Daily.)

 

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M&A in China — New China First Capital Research Report, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China”

Leave a Comment / June 18, 2013

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M&A in China is entering a new, more promising phase. At no previous time was the environment as favorable to identify and close, at attractive valuations, the acquisition of a profitable, high growth, well-run, larger private business in China.

This is the conclusion of a recently completed research study by China First Capital, as part of our M&A advisory work. (An abridged copy of the report is available by clicking here.) The report is titled, “A New Strategy for M&A, Buyouts & Corporate Acquisitions in China: Sourcing and executing successful corporate acquisitions and buyouts from unexited PE deals in China“.

The industrial logic of doing acquisitions in China has never been in doubt. The scale, high annual growth rate and fragmented nature of China’s domestic economy all create a powerful attraction for control investors. The challenge has traditionally been a negative selection bias on the sell-side, that the Chinese companies available for purchase are often troubled,  state-owned, inefficient or poorly-managed. China’s best corporate assets, its larger private companies, were not previously available to control investors.

As a result, M&A in China, for all the predictions of an impending take-off, has never gotten into gear. The theory behind most deals, if there was one, was to tie two stones together and see if they float.

The reason for the positive change in the environment for control deals in China is the serious degradation in the environment for minority ones. Specifically, China’s private equity industry is in a state of deepening crisis. Having financed the growth of many of China’s best private companies, the PE firms are now finding it increasingly difficult to engineer a liquidity event before the expiry of their fixed fund life. They are emerging as distress sellers of desirable assets — in this case, strong PE-backed companies that are left without any other viable means for investors to exit.

As elaborated in earlier research reports from China First Capital, (read  here, here, here) there is a large overhang of over 7,500 unexited private equity deals in China. Most of these deals were done on the expectation of exiting through an IPO within a few years. That was always statistically improbable. In no year did more than 150 PE-backed Chinese private companies IPO.

An IPO has gone from statistically improbable to virtually unattainable. This is not only impacting the thinking of PE firms, but of the entrepreneurs they back as well. The exit math for private company bosses in China has changed dramatically over the last 12 months. M&A looks more and more like the only viable path to exit.

For business owners, the challenge to getting a deal done are both psychological and practical. First, owners must accept that valuations are way below where they hoped them to be, as well as well below the level two years ago, when they topped out at over 100 times last year’s net income. Second, the number of companies looking to sell will quickly begin to outnumber the qualified and capable acquirers. This will put further downward pressure on valuations.

In other words, for private company bosses looking for a liquidity event, the pressure to consider selling the business is mounting. For investors, owners and acquirers, the result is the beginnings of a genuine market for corporate control for private sector businesses in China.

The new China First Capital report is directed towards all three classes of potential acquirers — 1) global businesses seeking China market entry; 2) corporate acquirers seeking market or margin expansion in China through strategic or tuck-in acquisitions; 3) China domestic or global buyout firms seeking quality operating assets that can be built up and sold.  Their methods, timetable, metrics and deal targets will often differ. But, all three will find the current situation in China more suitable than at any previous time for executing M&A transactions of USD$100mn and above.

While the number of attractive targets is increasing, the complexities of doing M&A in China remain. The invested PE firms are almost always minority investors. A control transaction will need to be structured and staged to incentivize the owner to sell at least a portion of his holding alongside the PE firm, and then likely remain for at least several years at the helm.

The report offers some possible deal structures and timing mechanisms, included using “blended valuation” to determine price. It also charts the all-important  “when does cash enter my pocket” timing from the perspective of a selling majority owner.

PE investment in China, the report concludes,  has altered permanently the business landscape in China. It has also prepared the ground for a surge now in M&A activity.

Over $150 billion in PE capital was invested to propel the growth of over 10,000 private businesses. PE finance helped create a more dynamic and powerful private sector in China. In quite a number of cases, the PE-invested businesses have emerged as industry leaders in their sectors in China, highly profitable, innovative, fast-growing, with revenues of $100mn and above.

These companies have the scale and established market presence to permit a strategic acquirer to substantially increase its activity in China, extending product range, customer relationships, distribution channels. For buyout firms or corporate acquirers, taking over a PE-invested company should offer satisfactory financial returns. Buyout ROE can be significantly enhanced in certain cases by using leverage to finance the acquisition.

The supreme irony is that this moment of opportunity in domestic M&A comes at the same time quite a number of PE firms are pursuing highly questionable “take private” deals involving troubled Chinese companies listed on the US stock market. (See earlier blog posts here, here, here, here.) The risks, and prices paid, are far higher than doing well-targeted domestic M&A in China.

When junk is priced like jewels — and vice versa — is there any doubt where the smart money should go?

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Smithfield Foods – Shuanghui International: The Biggest Chinese Acquisition That Isn’t

1 Comment / June 14, 2013


It is, if voluminous press reports are to be believed, the biggest story, the biggest deal, ever in China-US business history. I’m talking about the announced takeover of America’s largest pork company, Smithfield Foods, by a company called Shuanghui International. The deal, it is said in dozens of media reports, opens the China market to US pork and will transform China’s largest pork producer into a global giant selling Smithfield’s products alongside its own in China, while utilizing the American company’s more advanced methods for pork rearing and slaughtering.

One problem. A Chinese company isn’t buying Smithfield. A shell company based in Cayman Islands is. Instead of a story about “China buying up the world”, this turns out to be a story of a precarious leveraged buyout deal (“LBO”) cooked up by some large global private equity firms looking to borrow their way to a fortune.

The media, along with misstating the facts, are also missing the larger story here. The proposed Smithfield takeover is the latest iteration in the “take private” mania now seizing so many of the PE firms active in China. (See blog posts here, here, here and here.) With China’s own capital markets in crisis and PE investment there at a standstill, the PE firms have turned their attention, however illogically, to finding “undervalued assets” with a China angle on the US stock market. They then attempt an LBO, with the consent of existing management, and with the questionable premise the company will relist or be sold later in China or Hong Kong. The Smithfield deal is the biggest — and perhaps also the riskiest —  one so far.

This shell that is buying Smithfield has no legal or operational connection to Henan Shuanghui Investment & Development (from here on, “Shuanghui China”) , the Chinese pork producer, China’s largest, quoted on the Shenzhen stock exchange. The shell is about as Chinese as I am.

If the deal is completed, Shuanghui China will see no obvious benefit, only an enormous risk. Its Chinese assets are reportedly being used as collateral for the shell company to finance a very highly-leveraged acquisition. The abundant risks are being transferred to Shuanghui China while all the profits will stay inside this separately-owned offshore shell. No profits or assets of Smithfield will flow through to Shuanghui China. Do Shuanghui China’s Chinese minority shareholders know what’s going on here? Does the world’s business media?

Let’s go through this deal. I warn you. It’s a little convoluted. But, do take the time to follow what’s going on here. It’s fascinating, ingenious and maybe also a little nefarious.

First, the buyer of Smithfield is Shuanghui International, a Cayman holding company. It owns the majority of Shuanghui China, the Chinese-quoted pork company. Shuanghui International is owned by a group led by China-focused global PE firm CDH, with smaller stakes owned by Shuanghui China’s senior management,  Goldman Sachs, Singapore’s Temasek Holdings, Kerry Group, and another powerful PE firm focused on China, New Horizon Fund.

CDH, the largest single owner of Shuanghui International,  is definitively not Chinese. It invests capital from groups like Abu Dhabi’s sovereign wealth fund , CALPERS, the Rockefeller Foundation, one big Swiss (Partners Group) and one big Liechtenstein (LGT) money manager, along with the private foundation of one of guys who made billions from working at eBay. So too Goldman Sachs, of course, Temasek and New Horizon. They are large PE firms that source most of their capital from institutions, pension fund and endowments in the US, Europe, Southeast Asia and Middle East. (For partial list of CDH and New Horizon Fund Limited Partners click here. )

For the Smithfield acquisition, Shuanghui International (CDH and the others) seem to be putting up about $100mn in new equity. They will also borrow a staggering $4 billion from Bank of China’s international arm to buy out all of Smithfield’s current shareholders.  All the money is in dollars, not Renminbi.

If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But, nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part-owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.

Shuanghui International, assuming it’s borrowed the money from Bank of China for three years,  will need to come up with about $1.5 billion in interest and principal payments a year if the deal closes. But, since Shuanghui International has no significant cash flow of its own (it’s an investment holding company), it’s hard to see where that money will come from. Smithfield can’t be much help. It already has a substantial amount of debt on its balance sheet. As part of the takeover plan, the Smithfield debt is being assumed by Morgan Stanley, Shuanghui International’s investment bankers. Morgan Stanley says it plans then to securitize the debt. A large chunk of Smithfield’s future free cash flow ($280mn last year) and cash ($139 mn as of the first quarter of 2013) will likely go to repay the $3 billion in Smithfield debts owed to Morgan Stanley.

A separate issue is whether, under any circumstances, more US pork will be allowed into China. The pork market is very heavily controlled and regulated. There is no likely scenario where US pork comes flooding into China. Yes, the media is right to say Chinese are getting richer and so want to eat more meat, most of all pork. But, mainly, the domestic market in China is reserved for Chinese hog-breeders. It’s an iron staple of China’s rural economy. These peasants are not going to be thrown under the bus so Smithfield’s new Cayman Islands owner can sell Shuanghui China lots of Armour bacon.

Total borrowing for this deal is around $7 billion, double Smithfield’s current market cap. Shuanghui International’s piece, the $4 billion borrowed from Bank of China, will go to current Smithfield shareholders to buy them out at a 31% premium.  Shuanghui International owns shares in Shuanghui China, and two of its board members are Shuanghui China top executives, but not much else. So where will the money come from to pay off the Bank of China loans? Good question.

Can Shuanghui International commandeer Shuanghui China’s profits to repay the debt? In theory, perhaps. But,  it’s highly unlikely such an arrangement would be approved by China’s securities regulator, the CSRC. It would not likely accept a plan where Shuanghui China’s profits would be exported to pay off debts owed by a completely independent non-Chinese company. Shuanghui International could sell its shares in Shuanghui China to pay back the debt. But, doing so would likely mean Shuanghui International loses majority control, as well as flooding the Shenzhen stock market with a lot of Shuanghui China’s thinly-traded shares.

Why, you ask, doesn’t Shuanghui China buy Smithfield? Such a deal would make more obvious commercial and financial sense. Shuanghui China’s market cap is triple Smithfield’s. Problem is, as a domestic Chinese company listed on China’s stock exchange, Shuanghui China would need to run the gauntlet of CSRC, Ministry of Commerce and SAFE approvals. That would possibly take years and run a risk of being turned down.  Shuanghui International, as a private Caymans company controlled by global PE firms,  requires no Chinese approvals to take over a US pork company.

The US media is fixated on whether the proposed deal will get the US government’s go ahead. But, as the new potential owner is not Chinese after all — neither its headquarters nor its ownership — then on what grounds could the US government object? The only thing Chinese-controlled about Shuanghui International is that the members of the Board of Directors were all likely born in China. The current deal may perhaps violate business logic but it doesn’t violate US national security.

So, how will things look if Shuanghui International’s LBO offer is successful?  Shuanghui China will still be a purely-Chinese pork producer with zero ownership in Smithfield, but with its assets perhaps pledged to secure the takeover debts of its majority shareholder. All the stuff about Shuanghui China getting access to Smithfield pork or pig-rearing and slaughtering technology, as well as a Smithfield-led upgrade of China’s pork industry,  is based on nothing solid. The pork and the technology will be owned by Shuanghui China’s non-Chinese majority shareholder. It can, if it chooses, sell pork or technology to Shuanghui China. But, Shuanghui China can achieve the same thing now. In fact, it is already a reasonably big buyer of Smithfield pork. Overall, China gets less than 1% of its pork from the US.

If the deal goes through, the conflicts of interest between Shuanghui International and Shuanghui China will be among the most fiendish I’ve ever seen. Shuanghui China’s senior managers, including chairman Wan Long, are going to own personally a piece of Smithfield, and so will have divided loyalties. They will likely continue to manage Shuanghui China and collect salaries there, while also having an ownership and perhaps a management role in Smithfield. How will they set prices between the two fully separate Shuanghuis? Who will watch all this? Isn’t this a case Shuanghui China’s insiders lining their own pockets while their employer gets nothing?

On its face, this Smithfield deal looks to be among the riskiest of all the  “take private” deals now underway. That is saying something since several of them involve Chinese companies suspected of accounting frauds, while the PE firms in at least two cases (China Transinfo and Le Gaga) doing the PE version of a Ponzi Scheme by seeking to use new LP money to bail out old, severely troubled deals they’ve done.

Let’s then look at the endgame, if the Smithfield deal goes through. Shuanghui International, as currently structured,  will not, cannot, be the long-term owner of Smithfield. The PE firms will need to exit. CDH, New Horizon, Goldman Sachs and Temasek have been an indirect shareholders of Shuanghui China for many years — seven in the case of CDH and Goldman.

According to what I’m told, Shuanghui International is planning to relist Smithfield in Hong Kong in “two to three years”. The other option on the table, for Shuanghui International to sell Smithfield (presumably at a mark-up) to Shuanghui China, would face enormous, probably insurmountable,  legal, financial and regulatory hurdles.

The IPO plan, as of now, looks crackpot. Hong Kong’s IPO market has basically been moribund for over a year. IPO valuations in Hong Kong are anyway far lower than the 20X p/e Shuanghui International is paying for Smithfield in the US. A separate tactical question for Shuanghui International and its investment bankers: why would you believe Hong Kong stock market investors in two to three years will pay more than US investors are now paying for a US company, with most of its assets, profits and revenues in the US?

But, even getting to IPO will require Shuanghui International to do something constructive about paying off the enormous $4 billion in debt it is taking on. How will that happen? Shuanghui International is saying Smithfield’s current American management will stay on. Why would one assume they can run it far more profitably in the future than they are running it now? If it all hinges on “encouraging” Shuanghui China to buy more Smithfield products, or pay big licensing fees, so Shuanghui International can earn larger profits, I do wonder how that will be perceived by both Shuanghui China’s minority investors, to say nothing of the CSRC. The CSRC has a deep institutional dislike of related party transactions.

Smithfield has lately been under pressure from some of its shareholders to improve its performance. That may have precipitated the discussions that led to the merger announcement with Shuanghui International. Smithfield’s CEO, C. Larry Pope, stands to earn somewhere between $17mn-$32mn if the deal goes through. He will stay on as CEO. His fiscal 2012 salary, including share and option awards, was $12.9mn.

Typical of such LBO deals, the equity holders (in this case, CDH, Goldman, Temasek, Kerry Group, Shuanghui China senior management, New Horizon) would stand to make a killing, if they can pay down the debt and then find a way to either sell or relist Smithfield at a mark-up. If that happens, profits will go to the Shuanghui insiders along with the partners in the PE firms, CALPERS, the Rockefeller and Carnegie foundations, Goldman Sachs shareholders and other LPs. Shuanghui China? Nothing, as far as I can tell. China’s pork business will look pretty much exactly as it does today.

In their zeal to proclaim a trend — that of Chinese buying US companies — the media seems to have been blinded to the actual mechanics of this deal. They also seem to have been hoodwinked by the artfully-written press release issued when the deal was announced. It mentions that Shuanghui International is the ” majority shareholder of Henan Shuanghui Investment & Development Co. (SZSE: 000895), which is China’s largest meat processing enterprise and China’s largest publicly traded meat products company as measured by market capitalization.” This then morphed into a story about “China’s biggest ever US takeover”, and much else besides about how China’s pork industry will now be upgraded through this deal, about dead pigs floating in the river in Shanghai, about Chinese companies’ targeting US and European brands.

China may indeed one day become a big buyer of US companies. But, that isn’t what’s happening here. Instead, the world’s leading English-language business media are suffering a collective hallucination.

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