Shenzhen

China’s Economy: From Red Light to Highlights

Cinnabar Enamel snuff bottle from China First Capital blog post

After 30 years of economic progress unparalleled in human history, China can rewrite the rules on which leading economic indicators are most important to track.  I want to nominate a new one: the rate at which brothels are converted to beauty parlors.

At least in my Shenzhen neighborhood, this indicator is certainly at an all-time high. In the last four months, two rather seedy massage and KTV parlors have undergone very lavish renovation and reopened as large, expensive, multi-floored hair-dressing salons.

The clear implication: you can make more money in China these days selling perms and dye jobs than selling sex. This is an economic change in China of historic, if under-appreciated, importance.

Shenzhen has long had a reputation as one of the red light capitals of China. Some of the reasons: proximity to Hong Kong, a transient population made up largely of economic migrants, a local government with more of a laissez-faire attitude than elsewhere in China.

I can’t imagine anyone but the local police are keeping count, but I’d guess there must be thousands of places in the city offering sex for cash. These range from tiny storefronts with five to ten girls in folding chairs, to all manner of sauna, massage and KTV joints, most, but not all of which, augment their more legitimate offerings with the paid option to take one of the hostesses home with you, or do a little groping on the premises.

Or so I’m told. I know it may sound either prudish or disingenuous, but I’ve never been a customer of one of these places. I do, however, marvel at the variety and number of places selling sex here. The five-minute walk from my house to the local supermarket takes me past two big neon-lit places, called 会所, or “clubs” with touts out front and some heavily made-up ladies within. Down two smaller alleys are small storefront brothels.

In the building where I live, one of the fancier ones in my neighborhood, business cards are slipped under my door most every night offering “home delivery services”. They stress the a variety of women available, including  nurses, college students, migrants, mistresses, foreigners.

This is the part of Shenzhen’s sex trade I most deeply object to. The cards are put under every door. The photos on the card are of naked women.  My next-door neighbors include Chinese families with young kids. It’s unseemly, and I’ve complained numerous times to the doormen, but they claim not to know who is responsible for distributing the cards. My guess is they are paid to look the other way.

The economics of hair-dressing are certainly more favorable than the economics of prostitution. It’s not unusual for a woman to spend Rmb200-300 or more on a haircut and shampoo. Get your hair colored and the price can double. Though there are already dozens of hair salons in my neighborhood, they all seem to be jam-packed at all hours of the day. That never looks to be the case of the places selling sex. They always seem empty, over-staffed and under-patronized.

One thing hairdressers and brothels have in common,  the busiest time is 9pm-1am. Hairdressers, most of whom are men, earn a pretty good living, making around USD$1,000 a month. But, they work long hours, usually 12 hours a day. Most of the customers are women, but these places also cater to men. I pay Rmb 50 for a haircut and no shampoo. That’s a little less than the cost of a haircut at the joint I used to go to in LA’s Koreatown.

Every new beauty parlor that opens is confirmation of some larger economic trends in China.  Women have more disposable income, and more of an inclination to spend it on fashion, cosmetics, or a new hairstyle.  Prices are quickly reaching levels similar to those in the US. In Shenzhen, a young woman can now easily earn as much every month sitting at a desk in an office as sitting in a storefront brothel. That is probably a change from a few years ago.

China’s economy is changing quickly from export-dependence to a reliance on the domestic market, from dominance of manufacturing to the rise of the service sector. In my part of Shenzhen, what’s changing most quickly: who is serving what to whom for how much.



Is This China’s Worst New Brand? Cambridge University Clothing

store

 

In a recent blog post, I discussed how and why Chinese brands are not just holding their own in China, but winning against global titans like P&G, Nike, Unilever, Coca-Cola. A big reason is that there are Chinese entrepreneurs with a great feeling for what kind of brand messaging works best in China. 

But, of course, success is not automatic. China can also produce its share of Edsel brands, clunkers that seem from the start preordained to fail.

One such case has some special resonance for me. There’s a new retail clothing brand in China called “University of Cambridge”. It was just launched a few months ago, and there are already about ten stores across China, including one in the Shenzhen shopping mall closest to where I live. The parent company is also based in Shenzhen. 

I was more than a little surprised to see the Cambridge clothing shop open. For one thing, my guess is that I’m one of probably fewer than fifty graduates of the English university living in Shenzhen (Cantab. M.Phil 1985) . So, the “captive population” is going to be very small. What’s more, from a quick look around, I wouldn’t be caught dead wearing any of their clothing , best described as a slinky, polyester mélange of “Ye Olde England” and futuristic Chinese design. 

But, the bigger reason I was surprised to see the University of Cambridge store open is that I can’t believe the university would grant a license to a Chinese retailer to use the University of Cambridge name. Yet, on the walls of the store, as well as on the label of the apparel, it says that this company does, indeed, have the official license from Cambridge. Also, stuck into a lot of the clothing on display are pins emblazoned with the Cambridge emblem: cantab2If anyone can verify that this is legit, that this university did give this Chinese entrepreneur a license, I’d certainly like to know. The store is so brazen in claiming to have the license it’s hard to believe they’re making it all up. But, it could be. 

The store claims they are the first ever to get this kind of license from the university, and that it was granted in 2009, the 800th anniversary of Cambridge’s founding. They also say they have big plans for global expansion. If they don’t have a valid license to use the Cambridge name, then of course any such plan is going to fail from the outset. 

But, if they do have the license, I’d suggest someone at Cambridge should be doing a better job controlling how its name is being used. The clothing is really atrocious. If it were just t-shirts and sweatshirts with the Cambridge logo, it would be one thing. But, the store only has its own designs, both men’s and women’s, and nothing that really connects the styles to the university. 

The store is not without its sources of amusement. In describing the university, it provides a list of famous alumni, based on various categories. My favorite among these: “Politicians: Charles, Mandela, Lee Kuan Yew”.  I’m guessing they mean Prince Charles, though it’s clearly a stretch to describe him as a politician. 

I’m a particularly bad “one man focus group” to evaluate which brands are going to be successful in China. On most things, my tastes are way out of whack with those of the host population. But, I’m pretty confident the Cambridge University retail chain is going to sputter and die. Associating yourself with a famous European institution is not a bad idea by itself, and lots of successful Chinese brands look to capture a kind of European cache. But, this stuff is just too ugly, and too expensive, to catch on. 

The target market seems to be very affluent middle-aged Chinese of both sexes. They have much better, safer and more tasteful choices in the same mall: including Ralph Lauren, Zegna, Lacoste, Louis Vuitton, Canali, Gucci.

Ford marketed its Edsel brand for two years, before killing it off in what is still the biggest and fastest failure for any mainstream auto brand. My guess is that University of Cambridge retail chain won’t survive even that long.


 

Shenzhen’s Place in China’s Long History Mixing Sex and Commerce

Shenzhen night time, from China First Capital blog post

Shenzhen is such a relentless modern city that it’s often hard to discern the influence of 3,000 years of Chinese history and culture. The skyline is so futuristic that it often resembles the home planet of a higher civilization.(See photo above, of the City Center and buildings near CFC’s office). 

But, of course, this is still a part of China, with all its embedded messages and references to a history longer and richer than any other. It just takes a little wisdom to perceive it. I can’t lay claim to any such wisdom. Luckily, though, I have a friend here who has both the historical knowledge and scholar’s temperament to properly put modern Shenzhen into a more classically Chinese context. 

This friend, Zhen Qinan, has had a exemplary career in the financial industry, first as part of the working team formed in 1990 to establish the Shenzhen Stock Exchange, and then as head of a joint venture between four Chinese financial firms and Merrill Lynch, where he worked with leading Chinese companies like Huawei and Taitai Pharmaceutical. 

These days, Qinan is semi-retired. I try to spend time with him whenever I can. He’s warm and thoughtful, and I know now from experience that he’ll offer astoundingly wise insights to even my most mundane questions. How mundane? Over a meal at one of Shenzhen’s better Sichuan places, I commented on how lucky we were to be in a city with so many good restaurants, even by Chinese standards. 

If I had to come up with reasons why, I would settle for the fact Shenzhen is richer than other cities, and has a population drawn from all parts of China. Qinan, however, offered a much richer explanation, rooted in his learning and respect for Chinese history. 

Shenzhen is part of an unbroken tradition, reaching back at least 1,200 years, of commercial centers in China having the best food and also the most beautiful women. So, in their day, the great trading cities along the Grand Canal — Hangzhou, Suzhou, Yangzhou — were particularly renowned as places with the finest and most varied cuisine, and the most desirable women. This reputation has remained largely intact in those cities, even as the commercial locus of China shifted elsewhere. 

The reason then, and the reason now, is the same: in wealthier commercial cities, there’s a heightened appreciation, as well as larger audience, for the pleasures that money can buy. Qinan is from Xian, and to drive home the point, he drew the comparison for me between Shenzhen and his home city.

Xian was always a center of learning and political power, rather than a city with vibrant trade and a large, successful merchant class. As a result, the food, though still quite delicious, has always been a little more basic, less expensive, less intricate, less subtle than that of the trading centers to the east, along the Grand Canal. There’s just not enough money around to support a thriving community of top-quality chefs and restaurants. They migrate to where the money is. 

The same logic, of course, applies to why beautiful women are more prevalent in rich commercial cities in China. Traditionally, beautiful women went to Suzhou, Hangzhou or Yangzhou to find a rich patron to take them as a subsidiary wife. They then produced better-looking children, on average, so creating a virtuous cycle. Let the process run, uninterrupted, for several centuries and the results would be that the cities gained a reputation, probably grounded in fact, for having particularly good-looking ladies. 

To this day, Chinese will always aver that Suzhou has the most beautiful women in the country. I haven’t been to Suzhou in over 25 years, so I can’t say if the reputation is deserved or not. But, I do know that most Chinese believe this to be true of Suzhou, even though, of course, few will have ever been there to see for themselves. 

While concubinage is officially no more in China, there is still a similar process at work in today’s Shenzhen. Concubines are no more. Polygamy is outlawed. Today, the term is 二奶 “er nai”, or “second lady”. It’s analogous to a mistress. Shenzhen, I’m told, has more “er nai” than any other city in China. These tend to be pretty girls in their early 20s who come to Shenzhen from all over China, and often end up clothed, housed, fed and otherwise supported financially by an older, usually married man. Nowhere else in the world (not Paris, Milan, or other centers of mistress culture) have I ever seen so many dreary older men in the company of stunningly beautiful women. 

Shenzhen has more “er nai” both because it’s the richest city in China, and also because there are a lot of men from neighboring Hong Kong who either live or work here, during the week. Part of the standard “expat package” would seem to be taking a Chinese girl as a mistress. I’m told the going rate, in terms of monthly cash stipend, is at least $1,000 a month, with apartment, car and clothing budget extra. That’s about five times more than a woman of similar age can make working in one of Shenzhen’s factories.

One other difference from the China of yore: these women will usually return to their home village with quite a nice nest-egg, marry locally and start a family. This then creates a “job opening”. The man will now find a new “er nai” and so start again the process of clothing, feeding and housing an attractive woman new to Shenzhen.   

Food and sex. They are life’s two most basic drives, as well as the fuel that has kept China’s commercial centers buzzing for well over a thousand years.

 

 

From China, a Plan to Topple One of America’s Most Dominant Brands

China First Capital blog post -- China private equity

Every list of America’s most valuable brands includes the same parade of names, year after year – Coca-Cola, McDonalds, Disney, Google. Every year, these lists also ignore what could be the single most dominant brand of all. This brand is known by everyone in America, enjoys a higher market share than any of those on the list, and is able to charge a price premium as much as 300% above its competitors. The brand? Crayola Crayons

That’s right, that most humble and low-tech of children’s toys. No one outside the company knows Crayola’s exact market share. A good estimate is at least 80% of the US crayon market. Maybe higher. In other words, Crayola is dominant enough not just to warrant an anti-trust investigation, but to be broken up as a monopoly. 

Of course, I’m partly joking here – about the anti-trust part, not about the market share. Heaven forbid the US Department of Justice should ever decide to police kids toys. But, Crayola really is astoundingly powerful and dominant in its market. It enjoys, according to the company’s own research, 99% brand recognition in the US. Its name is not only synonymous with crayons, but has more or less shut down any lower-cost competitor from grabbing much of its market share. How it does this is also something of a miracle, since as far as I can tell, they do comparatively little advertising to sustain this. In other words, they are not only the most dominant brand, they are also the thriftiest, in terms of how much is spent each year sustaining that position in parents’ minds and kids’ playrooms. 

We don’t know exactly how big Crayola is, or any other fact about its financial performance, because it’s a private company. In fact, even more impenetrably, it’s a private company inside a private company. Binney & Smith, the original manufacturer, was sold to famously-secretive Hallmark in 1984. It’s all educated guesswork. 

But, I’m lucky to know a Chinese boss whose guesswork is far more educated than most. David Zhan is boss and majority shareholder of Wingart, a manufacturer of children’s art supplies based in Shenzhen. David is one of the smartest, savviest and most delightful businesspeople I know. Wingart is also one of my very favorite companies – though they are not a client, nor an especially large and fast-growing SME. But, Wingart is exceptionally well-run and focused, with well-made and well-designed products, as well as the most kaleidoscopically colorful assembly line I’ve ever seen. 

Wingart makes crayons. They are better than Crayola’s. That’s not David’s pride speaking, but the results of some side-by-side testing done by one of the larger American art supply companies. I personally have no doubt this is true. I’ve seen Wingart’s crayon production. Not only are they better, but they are much cheaper too. 

Still, it’s almost impossible for Wingart to gain any ground on Crayola. Wingart mainly sells under other companies’ brand names in the US, including Palmers, KrazyArt and Elmer’s. They have good distribution for many of their products at Wal-Mart and Target. But, not crayons. Wal-Mart would like to start selling Wingart’s crayons – not just, presumably, because they are better than Crayola. But, Wal-Mart, famously, does not like to be reliant on a single brand, a single supplier, for any of the products it carries. 

For the time being, Wingart’s factory is too small to produce crayons in the quantity Wal-Mart requires. This should change within a year or so, when Wingart moves to a new and larger factory about two hours from Shenzhen. Then, perhaps for the first time ever, Crayola will begin to face some real competition. I can’t wait. I think Wingart has a realistic chance to build a crayon business, worldwide, that will compete in size with Crayola, which is pretty much a US-dependent company. 

I have a lot of admiration for Crayola – not so much the crayons, but the fact that a 106 year-old brand could be so predominant in its market, and enjoy such unrivaled – and largely uncelebrated — supremacy for so long. But, I’d still like to see Wingart knock them down a few notches, or more. Crayola has it too good for too long.  American kids deserve the best crayons – as, for that matter,  do European, Chinese and other kids on the planet.

International Investors Miss The Boat in China – Because They’re Not Allowed Onboard

China First Capital blog post Ming jar

Despite my fourteen years living in London,  I needed to fly all the way back to that city this week, from China, to finally get a look at Westminster Central Hall, a stately stone pile across the street from the even statelier, stonier pile that is Westminster Abbey. Central Hall does double duty, both as a main meeting place for British Methodists, and also as an impressive venue for conferences, including the first meeting of the United Nations in 1946. 

This week, it was site of the annual Boao Forum for Asia International Capital Conference. I flew in to attend, and participate in a panel discussion on private equity in China. The Boao Forum is something like the more renowned Davos Forum, but with a particular focus on Asia and China. This annual meeting focused on finance and capital, and drew a large contingent of about 120 Chinese officials and businesspeople, along with an equal number of Western commercial bankers, lawyers, accountants, investors, politicians, academics and a few other investment bankers besides me. 

Central Hall is crowned by a large domed ceiling, said to be the second-largest in the world. I enjoyed sending back a brief live video feed to my China First Capital colleagues in Shenzhen, whirling my laptop camera up towards the dome, and then down to show the conference. It was also the first time any of my colleagues had seen me in a suit. 

The weather was a perfect encapsulation of British autumn climate, with blustery and frigid winds, occasional radiant sunshine and torrential rain. It was my first trip back to London in over two years, and nothing much had changed. What a contrast to China, where in two years, most major cities seem to undergo a radical facelift. 

“How can a non-Chinese invest in Chinese private company?” It was a straightforward question, by a London-based money manager, for the panel I was on. Straightforward, even obvious, but it was actually one I’d never really considered before, to my embarrassment. In my talk (see Powerpoint here: http://www.chinafirstcapital.com/blog/wp-content/uploads/2009/08/trends-in-private-equity.pdf) , I made the case about why Chinese SME are among the world’s best investment opportunities for private equity firms.  It’s an argument I’m used to making to conference audiences in China. This is the first time I’ve done so anywhere else. The question, though, made me feel a bit like a guy telling his friends about the new Porsche Carrera for sale for $8,000, but then saying, “unfortunately, you’re not allowed to buy one.” 

The reality is that it’s effectively impossible for a non-Chinese investor, other than the PE firms we regularly work with,  to buy into a great private Chinese SME. For one thing, the investor would need renminbi to do so, and there’s no legal way to obtain it, for purposes like this. Even if you found a way around that problem, you’d face an even steeper one when you wanted to exit the investment and convert your profits back into dollars or sterling. 

The money manager came up to me later, and I could see the vexation in her eyes. I had persuaded her there were great ways for investors to make money investing in SME in China. Disappointingly, her clients aren’t allowed to do so. Cold comfort was all I could offer,  pointing out the same basic problem exists for any non-Chinese seeking to buy shares quoted on the Shenzhen and Shanghai stock markets. 

It’s a reasonable bet that China eventually will liberalize its exchange rate controls and ultimately allow freer convertibility of the renminbi. But, that doesn’t exist now. As a result, financial investment in renminbi in China is, for the most part, reserved exclusively for Chinese. Unfair? It must seem that way to the sophisticated, well-paid money managers in London, who these days have few, if any,  similarly “sure fire” investment options for their clients. 

China is, itself, awash in liquidity, and sitting on a hoard of over $2 trillion in foreign exchange reserves. So, there really is no shortage of capital domestically. Allowing foreign investors in, of course, would increase the capital available to finance the growth of great companies. But,  it will also add to the mountain of foreign reserves and put more upward pressure on the renminbi. That’s the last thing Chinese authorities need at the moment. So, most of the best investment opportunities in China are likely to remain, for quite a lot longer, open only to Chinese investors. 

Overall, this is a very good time to be Chinese. By my historical reckoning, it’s the best since at least the Tang Dynasty over 1,000 years ago. China has changed out of all recognition over the last 30 years, creating enormous material and social gains. That beneficial change, if anything, is accelerating. The fact Chinese also have some of the world’s best investment opportunities to themselves is just another dividend from all this positive change. 

If I were a money manager, I’d also be asking myself “how can I get some of this?” But, I’m not a money manager, and I formulate things very differently. I’m so happy and privileged to have a chance to help some of China’s great private entrepreneurs. Me and my team invest all our waking hours and all our collective passion in this. We are rewarded daily, by the trust put in us by these entrepreneurs, and by our very small contribution to their continued success. That’s more than adequate return for me.

I guess I’m not cut out for purely financial investing. 

 

Joys of Chinese Language: Discovering A Business Model

 

Jin Dynasty from China First Capital blog post

My Chinese language skills remain sub-standard. At best. But, that doesn’t prevent me from taking enormous pleasure in my wall-to-wall waking-hours’ immersion in Chinese. Often, it’s just the sound and cadences of Chinese local accents, which occur in extraordinary numbers and varieties. Even calling them “accents” doesn’t capture the bewildering array, since to an English speaker, the comparison that comes to mind is likely the difference between an English and American accent. In China, regional accents can be so extreme they are mutually incomprehensible. I often feel like the most common phrase I hear in Chinese is “What?”, accompanied by a puzzled expression that shows the listener didn’t catch a word of the Mandarin just spoken at him. 

In other words, I often feel like I’m in the majority in China that’s in the dark about the meaning of someone else’s spoken phrases. But, of course, that’s not quite the case. Chinese do just fine here. I stumble, fall flat, get back up and trip again. Again and again. That about sums up the path of my linguistic development. 

There are moments of transcendence as well. For example,  in Shenzhen recently, I listened in on pitches by six Chinese companies seeking private equity or venture funding. They were from different industries, but I heard repeatedly the phrase “shangye moshi” in the presentations. The first ten times or so, I just let it pass through my brain unmolested, assuming it was just another word that was outside my active vocabulary. Then it hit me. I knew both words: “shangye” means business, “moshi” means model, or method. Put them together, you get 商业模式, or “business model”, an increasingly common business jargon term in English that I now know was translated literally into Chinese. 

I never liked the term “business model” in English, and so rarely use it. Companies have a way of making money, it seems to me, not a “business model”. Models are static, not dynamic, ever-mutating structures, which is what most good companies must be in order to keep making money. 

But, my aversion to the term disappears in Chinese. I’ve taken it to using it quite often now. Why? For one thing, at my age, it’s rare that any new word will stick around long enough in my memory for me to use more than once. I’m on an email list that sends me seven Chinese words every day. I read today’s words about 15 minutes ago, and I’ve already forgotten half of them. By tomorrow, the rest will probably be gone also. So, the fact I’ve retained “shangye moshi” is already cause for minor celebration.

The other reason is that it does seem to fill a slight conceptual void in Chinese. Languages, including Chinese,  often import foreign phrases for this reason. Two other well-known Chinese examples of this are “lang man” and “you mo”, meaning “romantic” and “humor”, both of which entered as corrupted versions of the English original. Others have speculated about what this says about China, that it had no native words for “romantic” and “humor”, but I’ll leave that to theoreticians. 

With “shangye moshi”, the missing native concept in Chinese was likely a simple way of saying a company has a recurring source of profit. If so, of course, it’s a welcome addition to the Chinese language, and one hopes, to Chinese management strategy as well.

 

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

Imperial portrait from China First Capital blog post

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

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

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

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

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

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

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

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


 

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Trusting the Free Market — China Betters the US

chart for China First Capital blog post

“Chimerica”, “the world’s most important bilateral relationship”, “the G2”. These are phrases now in vogue to describe the relationship between China and America. The two countries tower over much of the rest of the world, accounting for over 25% of its population and 60% of global economic growth over the last five years. While China and the US continue to have their squabbles, economic and political relations are better than at any time in my lifetime.

My own life has been one long and fulfilling love affair with both countries, They represent twin poles of attraction. I grew up as a typical American kid, except in one respect. As far back as I can remember, I was completely fascinated by China. I believed that if I dug a deep enough hole in my backyard, I’d eventually come out in China. I kept starting the hole, especially when I was frustrated with my parents, but don’t recall ever getting very far. To me , the best thing about going off to university was that I could finally begin studying Mandarin. The most exciting day of my life (and I’ve had my fair share) was the day I walked across the Lowu Bridge in Hong Kong and into China for the first time in 1981.

My life’s goal became first to learn more about China, to study there and finally, after a lot of interesting career twists, to contribute whatever experience and talents I have to help China’s continuing economic transformation. That is why, two years ago, I started building China First Capital, a boutique investment bank that works with China’s private SME to arrange pre-IPO private equity finance.

I’m now lucky enough to call both countries home, dividing my time between Los Angeles and Shenzhen. Of course, there are more differences than similarities. For one thing, the food is better in China, and the summer weather is better in Los Angeles. But, all the same, I’m often struck by the deep affinities between China and the US – both are self-confident, continental-sized nations, with a shared sense of patriotism and optimism.

But, there is one important way in which the countries are moving in opposite directions. In this case, there is going to be a clear winner and a clear loser.

Americans are drifting further from their once unshakable belief in free markets. Chinese, meantime, are becoming ever more certain that the free enterprise system is the best way to organize society and fulfill the goals of its citizens. This is a very worrying development for the US, and a wholly positive one for China.

This remarkable shift is born out in the chart at the top of this post. It shows how Americans’ faith in free market system has been eroding, while Chinese are ever more certain of its superiority.

As someone working with some of China’s better entrepreneurial companies, I’m tremendously heartened by this change in China. The belief in free markets is affirmed by many daily interactions I have there, whether it’s with the boss of a successful private Chinese company, or the family that serves me steamed dumplings for breakfast. Chinese see opportunities everywhere for self-advancement, and want only the freedom to pursue it. Americans, by contrast, have grown more disillusioned, fearful. They are looking to the government, more than at any time I can recall, to solve their problems, to soothe what ails them.

How did China get it so right, while America is getting it so wrong? Recent history plays a big part. China has experienced unprecedented economic growth over the last 30 years, largely through a rolling program of reform that liberalized ever larger parts of China’s once hidebound economy. China’s economy has grown ten-fold over that time. Each additional increment of market freedom has brought with it improvements in the wellbeing of most Chinese citizens.

In the US, people are still reeling from the economic shocks of the last year – the credit crisis, recession, unemployment at a 27-year high, bailouts and bankruptcy of some of the country’s largest and most well-known businesses. Americans are looking for something to blame. Unfortunately, too many are blaming the free market system. Mistakenly, they look to government to restore growth and prosperity.

In China, on the other hand, the economy is vibrant, and Chinese have more opportunities than ever before, If they are looking to government for anything it’s to continue to maintain a steady course by continuing to liberalize.

I’m no pollster. But, I do notice, as I move between two countries, that not only is the belief in free markets stronger in China these days, but the overall business climate is more favorable as well. Competition is increasing, delivering more choice, better service, lower prices.

The US, meanwhile, is experiencing the largest increase in the size and scope of the government in peacetime history. Most people are smart enough to know that this will eventually mean more intrusive regulation and higher taxes — the twin forces that most choke a laissez faire system.

My sense is that the pendulum will eventually swing back in the US. People will be reminded soon enough that government cures are often worse than the underlying disease.

In China, economic liberty is increasing steadily, and life continues to get better for the vast majority of China’s vast population. If anything, this process is accelerating. China is, of course, still far less economically developed than the US. There are economic challenges, and issues on the horizon like an aging population to deal with.

But, at this particular moment in China, the population is growing more confident that solutions will come with freer markets, not greater centralized control. That is great news for everyone, including the companies we work for in China. The sooner Americans start thinking the same, the better.

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Companies That Can IPO & Companies That Should: The Return to IPO Activity in China

Ming Dynasty lacquer in China First Capital blog post

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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Eight Eight Oh-Eight

Today is a day of immense satisfaction and pride for the Chinese, and for those of us who aspire for China’s success and progress. The 2008 Beijing Olympics have begun, and quite literally, the eyes of the world are on China. A remarkable four billion people, or nearly 2/3 of the inhabitants of this planet, are expected to watch the Olympics over the next two weeks. The image many will form of China will be of a proud and ancient civilization restored to greatness. 

I celebrate the day, and its wider significance. It was 37 years ago, in the spring of 1971,  that I, along with most Americans of my generation and older,  got their first live televised glimpses of China. Nine American ping-pong players, accompanied by a larger number of American journalists, became the first official delegation to China since the founding of the People’s Republic in 1949. 

Less than a year later, Richard Nixon paid his historic visit. I was just a boy, but can still remember the excitement and awed wonder on seeing my first live images of the Great Wall, Tiananmen Square and the Summer Palace. It was also deeply inspiring. I was totally (and as it turns out, permanently) fascinated by China from the earliest age, and these images on the TV gave direction and purpose to my life even then. I had to learn Chinese and get to China!

It took a decade, but in 1981, I arrived in China for the first time, crossing the Lowu bridge on foot, arriving in a Shenzhen that was then a small border village of 30,000. Today, it is a city of over 13 million.  It was one of the happiest days of my life. I’d fulfilled that childhood goal of going to China. My goal changed that day, to one I’m still pursuing – building a deeper personal understanding of China, and a commitment to its future.  

I went straight to Beijing, and remember instructing the taxi driver at Beijing Station (in my very clumsy Chinese) to drive direct to Tiananmen. I spent the next few days, from my base at the Friendship Hotel out by Beida, riding trams and visiting the same places I’d seen on American TV 10 years earlier. I later took the train from Beijing to Nanjing, to do postgraduate work at Nanjing University.

It didn’t take long for me to realize that China’s greatest attraction wasn’t its historical sites, but its people. 

Then, as now, I felt deeply at home in China. The lesson: home is not just the place one is from, but where one feels the strong sense of belonging, comfort and happiness. For me, that makes China home, even when I’m far away, as now, in California.

Over the next two weeks, hundreds of millions of people will see their first live televised images of China. Some surely will form a goal similar to mine long ago – to study the culture and language of the country, and plan a visit someday.

I’m American by birth. Yet, my own ambitions, personal and professional with China First Capital, are to contribute to the continued transformation of China into a nation of great progress and prosperity. There is no greater reward than working for something larger than oneself.

For me, 8-8-08 is primarily a day to celebrate China’s achievement. It’s also a day when I celebrate the opportunity to work alongside smart and talented people committed as well to building and financing  the next generation of world-class Chinese businesses. 

 

A joyful return to China

I’m a very happy man today.  After several weeks in the US, I’m back in China. Nowhere else on this planet more pleases, inspires, awes and  enchants me.  I have a very long – just about life-long, in fact – love affairs with China.  As a boy growing up in the US during the height of the  Cold War, China was remote, closed, secretive, hostile to US foreign policy – and deeply fascinating, to me. More fascinating, in fact, than anywhere or anything else. I can’t entirely explain why. Maybe it was Nixon’s visit in 1972. Or, more likely, my early, and abiding, love of my grandfather’s exquisite Ming and Ching dynasty jade collection, which I’m now very proud to own. (The photo on the left is one of the pieces from my grandfather’s collection, a vase from the Ching Dynasty.)

All I know is that as soon as I got to university in the US, I enrolled in Chinese class, and declared myself a Chinese history major. My first visit to China was 1981, when I arrived as a postgraduate student at Nanjing University.

My intent back then was to devote my life to China – working, living and learning. In fact, my career path took an unexpected course and I ended up in Europe for 15 very happy and rewarding years, many of them spent as a foreign correspondent, traveling to well over 60 countries. From there, I moved on to Los Angeles to run a venture capital firm, and then lead a finance business during its US IPO.  I visited China during these years, but until last year, never had the opportunity to do what I’d long hoped and planned to do – work and live in China.

China First Capital is a culmination of my life’s dreams, hopes, and goals. 

I divide my time now between LA and Shenzhen, maintaining an office and home in each place. I feel intensely fortunate now to be involved in my work in the most important and history-changing development of our time: China’s rapid rise to economic greatness.  This work is deeply meaningful and fulfilling for me, because I have this long and unbreakable bond (in my heart as well as my mind) to this country. China is reassuming its role at the epicenter of world commerce, and everyone in the world, quite literally, benefits from this.

Right now, I have one specific, personal benefit in mind. Just as soon as I shower and unpack, I’m off for a delicious lunch of Sichuan food at a local place where I’ve gotten to know the owners, an extended family from Chongqing.