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Bill Gross, America’s “Mr. Unicorn”, Plots A Future in Asia

Leave a Comment / November 18, 2016

 

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Few technology entrepreneurs start one unicorn, a tech company with a market valuation of over $1 billion. Elon Musk has started three. Xiaomi’s Lei Jun two. Bill Gross has started and exited from seven, and has another two in his active porfolio.

Gross is the founder and chairman of Idealab, one of America’s oldest and probably still most successful technology incubators. Idealab was established in 1996. Gross was 38 years old then. He had already started and sold two software companies. He decided to take some of that money, as well as some from investors he knew, and start his own incubator.

From the beginning, Idealab has pursued a unique path among technology investors in California. Unlike most other incubators and VC funds, Gross himself comes up with most of the ideas for the new Idealab companies. Idealab then provides the first round of capital for each new company, hires a CEO and Gross takes on the role as non-executive chairman. Idealab has a full-time team to manage the back office work like HR and accounting for new companies during their early stages.  Idealab headquarters is in an old brick warehouse in the California city of Pasadena, near Los Angeles, and close to Caltech, where Gross went to school.

In the last 20 years, Gross has started 150 businesses. Of these, 45 have had successful exits, either through IPOs or M&A. A similar number are still in the Idealab portfolio.

The unicorns Gross created include some of the most successful early successes in e-commerce and online advertising. The companies are: eToys, Overture, Tickets.com, Netzero, Centra, Shopping.com and  Citysearch. Two other Idealab companies have recently merged with other tech startups. These merged companies, Twilio and Taboola, also now have valuations above $1 billion. Over the years, Gross also started and sold companies to Google, eBay, AOL, AirBNB. Along with internet companies, Gross has also started companies in solar and renewable energy, robotics, online education, wireless networking, 3D printing machinery, home medical care.

Gross long ago stopped raising money from outside investors. Idealab is a corporation, not a fund. Gross has the kind of freedom most tech entrepreneurs can only dream of – the imagination and drive to start new technology companies, a few new ones every year, and the capital to help them grow. Idealab’s capital contribution into each new company is about $250,000. If a company begins to grow according to plan, Idealab then raises outside money from VC firms, mainly the large ones based in Silicon Valley. Idealab’s return on invested capital up to now: 13.5 times.

Gross was born in Japan, but moved to California as a boy and got his start as an entrepreneur while in middle school. For 20 years, he has seen technology business opportunities earlier than most people. Anyone interested in where technology is headed, the important problems it may solve, how to incubate successful startups, and how China and East Asia may become more deeply integrated into California’s innovation ecosystem should listen to what Gross has to say.

 

Venture capital investing and incubators have grown very large in the last few years, both in the US and also elsewhere including China. There’s still a lot of capital looking for good ideas. Let’s dissect please how you look at the world. What are the key “metatrends” you see that will impact the shape and size of the global economy over the next 35 years?

Let me take you through those quickly. Start with population growth. The projections are there will be 9.7 billion people on the planet by 2050, up from 7.4 billion today. Larger population means lots of possibly negative impacts and so areas where technology needs to come up with new solutions. What are the major challenges in the future? I think mostly about six. I’m an engineer, so let me give you a list:

  1. climate change;
  2. how to the meet the need to provide better, more affordable healthcare and prevention against global epidemics
  3. food security, having enough safe food available across the world
  4. the growing technological divide between people living with the benefits of modern technologies and those who are left behind
  5. the workforce of the future, how to make sure people have the right skills to find productive jobs
  6. the future of the internet, how to provide security and privacy to everyone using it.

 

The people working to solve these problems probably hope to win Nobel Prizes, not become technology entrepreneurs.  So, where do you see the concrete business opportunities, where there’s both a future market and a potential for some kind of new technology breakthrough?

Of course, you wouldn’t expect me to hand over the keys to my kingdom, to give you the exact business areas we are now working on. But, I can share the industries where I think there’s lots of opportunity worldwide and where we’re actively coming up with new business ideas and looking to start new companies. Again, if you don’t mind, let me give it to you as a list.

  1. Autonomous cars and drones
  2. Clean water and clean energy
  3. New education models, including MOOCs
  4. Agriculture technology, including urban farming, growing food closer to population centers
  5. Advanced machine-meaning and deep neural networks to provide better, smarter data and decision-making
  6. 3D Printing, using metal, new materials
  7. IoT consumer and business
  8. Home automation
  9. Virtual reality and human-computer interaction
  10. New forms of transportation, including hyperloop and perhaps even flying cars
  11. Space, inexpensive launches, to space mining and microsatellites
  12. Software and information security systems to manage each of these

While it’s still possible to start successful companies with limited capital and get to market quickly as we’ve been doing for the last 20 years, some of the newer business opportunities I like will need much larger amounts of money and a longer incubation period. But, the rewards for success will be larger than anything we’ve seen up to now.

 

Up to now, you’ve focused only on building breakthrough tech companies in California to serve to US market. There are other places in the world with money and markets for good technology.

Yes, I definitely see a fusion of powerful and positive forces taking place in Asia that could allow Greater China to emerge as an important constituent in globally-important innovation, both as a market and as a base of ideas and manufacturing. This will be good for China, good for Asia, good for the US, good for the world.

I’m an inventor, and so have always looked to China. I have huge respect for the ingenuity, diligence and entrepreneurship of the Chinese people. Look at the example of China’s greatest inventor, Lu Ban, who lived almost 2,500 years before America’s Thomas Edison. He came up with ideas for flying machines and all kinds of advanced wooden implements .

 

So what role can you envision China playing as one of the world’s centers of technology innovation?

China, like the US, is a place where a large domestic market, manufacturing strength, capital and entrepreneurial culture all come together.

A few years ago, I gave myself a challenge, to come up with one new business idea every day.  I’ve mainly been able to keep up that pace. We could start even more companies, but there’s often one big constraint. We can’t find enough great people to run each new company. Greater China is blessed with having a large number of talented managers and engineers. That’s a huge and valuable resource. On the downside, intellectual property protection in China isn’t nearly as robust as it needs to be.

 

All of Idealab’s billion dollar exits happened during the early years of the internet, with IPOs for companies including eToys, Citysearch, Tickets.com and the sale of online-advertising business Overture to Yahoo. Have big exits become harder?

IPOs have certainly slowed down. The total number of annual IPOs in the US has been falling since we got started 20 years ago. It used to be over 300 companies on average IPOd every year in the US. It’s now below 100. This year is looking like one of the slowest for US IPOs. A big reason is the cost and regulatory burden of being a public company in the US. Our exits now come from M&A.  We continue to do pretty well.

Let me quickly go over our three of our most recent M&A exits. The three are all in different industries — mobile phone security, solar energy and robotics. We started Authy to provide simple but more effective mobile phone data and transaction security. We merged it last year with Twilio, which IPOd this summer on the New York Stock Exchange and now has a market cap of over $4 billion.

RayTracker is a company we started to improve the performance and energy production from solar panels by getting them to track the movement of the sun across the sky. This has been a passion of mine since high-school, to make solar energy more affordable and efficient. We sold RayTracker to First Solar, a Nasdaq-listed company. Today ground mounted trackers like RayTracker invented account for more than 90% of all solar installations in the US and First Solar is a leader the field.

The other recent exit is a little bittersweet, because we may have come to market a little too early with a product consumers originally didn’t really understand. They do now. Being too early with an idea can lead to failure just as quickly as being too late.  Our company was Evolution Robotics, which was probably the first company to design hardware and software for a home robot to clean floors. We had to come up with substantial new technology in vision recognition and spatial mapping, including our own proprietary indoor GPS system using infrared. We sold our company to a competitor, iRobot, which is now by far the largest company in this industry.

 

Can we have a peek inside the current Idealab portfolio? Talk to us about companies you think have the potential to grow into billion dollar businesses within the next few years?

I mentioned already my lifelong passion for clean energy and making solar energy cheaper and more efficient. We have two companies now, Edisun and Cool Energy, that have unique solutions that are finding a lot of market acceptance. Edisun both generates and stores solar energy, so it can be delivered to the grid when it’s needed. Cool Energy uses a Stirling Engine to capture low temperature waste heat, like from machines in a large factory, and turn it into clean electricity.  It can also make electricity from waste cold, like the huge refrigeration vessels used for LNG storage.

Mark Andreesen, the guy who invented the first commercial web browser and is now a successful venture capital investor, has said that “software is eating the world”. He means that just about every product and service is going to need more and better software in the future. I agree. The problem is, where are all those new software engineers going to come from? We’ve started two companies to teach kids how to write software, CodeSpark and Ucode. We’re noticing CodeSpark has more and more kids in China using it to learn to write software. We need to come up with a Chinese version, as well as Japanese, Korean.

One other area where we see huge potential is capturing and analyzing more and better mobile data, then using it for more efficient advertising. This could be as big a future market as “Pay-per-click” online advertising that earns so much money for Google and Baidu. I have a longer history in this area than most people. Overture, a company I started and sold to Yahoo for $1.6 billion in 2003, was an early successful pioneer of online advertising.

 

In the last 20 years, you’ve started 150 businesses, and had ideas for hundreds of others. Few people anywhere at any time have done that much business creation. What you have you learned about the reasons why start-ups succeed and fail?

I believe that the startup organization is one of the greatest forms to make the world a better place. If you take a group of people with the right equity incentives and organize them in a startup, you can unlock human potential in a way never before possible. You get them to achieve unbelievable things.  But if the startup organization is so great, why do so many fail?

This matters to me as an investor and entrepreneur. I’ve started more failed companies than probably just about anyone else. They all looked promising at the beginning, had money and people in place, but ended up dying. Each time a company fails it’s heartbreaking for the entrepreneur. So, trying to get some usable analysis on this process may end up reducing the failure rate for me and I hope many others too.

I tried to look across what factors accounted the most for company success and failure. So I looked at the five key factors — the idea, the team, the execution, the business model and the timing. It accounted for 42 percent of the difference between success and failure. Team and execution came in second, and the idea, the differentiability of the idea, the uniqueness of the idea, actually came in third.

 

After 20 years at Idealab, and twenty years before that starting and running your own start-ups, aren’t you getting tired of this, the pressure, the risk, the uncertainty of starting new companies? There’s got to be an easier way to earn a living.

I think we are in a very exciting time where technology and innovation permeates everything we do, and every company.  If the previous 20 years of my life were devoted to fostering entrepreneurship, I would love my next 20 to be about pushing new technological boundaries to make the world a better place. To happen, it’s going to need Asia and California to push together.

 

Version as published by Nikkei Asian Review

Chinese version as published by Caijing Magazine (财经杂志中文版）

Bill Gross’s TED Talk on why startups succeed

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US Private Equity Soars While China Stalls

1 Comment / February 9, 2015

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In 2014, the gap between the performance of the private equity industry in China and the US opened wide.  The US had a record-breaking year, with ten-year net annualized return hitting 14.6%. Final data is still coming in, but it appears certain US PE raised more capital more quickly and returned more profits to LPs than any year previously.  China, on the other hand, had another so-so year. Exits picked up over 2013, but still remain significantly below highs reached in 2011. As a result profit distributions to LPs and closing of new China-focused funds are also well down on previous highs.

China’s economy, of course, also had an off year, with growth trending down. But, it’s hard to place the blame there. At 7.5%, China’s economy is still growing at around triple the rate of the US. China’s publicly-traded equities market, meanwhile, turned in a stellar performance, with the overall Chinese stock exchange average up 52% in 2014, compared to a 11.4% rise in the US S&P. When stock markets do well, PE firms should also, especially with exits.

While IPO exits for Chinese companies in US, HK and China reached 221, compared to only 66 in 2013, the ultimate measure of success in PE investing is not the number of IPOs. It’s the amount of capital and profits paid back to LP investors. This is China PE’s greatest weakness.

Over the last decade, China PE firms have returned only about 30% of the money invested with them to their LPs. This compares to the US, where PE firms over the same period returned twice the money invested by LPs. In other words, in China, as 2015 commences, PE firm investors are sitting on large cash losses.

China private equity distributions to LPs

 

China PE firms say they hope to return more money to their LPs in the future.  But, this poor pay-out performance is already having an adverse impact on the China PE industry. It is getting harder for most China PE firms to raise new capital. If this trend continues, there will be two negative consequences – first, the China PE industry, now the second largest in the world,  will shrink in size. Second, and more damaging for China’s overall economic competitiveness, the investment capital available for Chinese companies will decline. PE capital has provided over the past decade much-needed fuel for the growth of China’s private sector.

What accounts for this poor performance of China private equity compared to the US? One overlooked reason: China PE has lost the knack of investing and exiting profitably from Chinese industrial and manufacturing companies. Broadly speaking, this sector was the focus of about half the PE deals done up to 2011 when new deals peaked. That mirrors the fact manufacturing accounts for half of China’s GDP and traditionally has achieved high levels (over 30%) of value-added.

Manufacturing has now fallen very far from favor in China. Partly it’s the familiar China macro story of slowing export growth and margin pressures from rising labor costs and other inputs. But, another factor is at work: China’s own stock market, as well as those of the US and Hong Kong, have developed a finicky appetite when it comes to Chinese companies. In the US, only e-commerce and other internet-related companies need apply for an IPO. In Hong Kong, the door is open more widely and the bias against manufacturing companies isn’t quite so pronounced, especially if the company is state-owned. But, among private sector companies, the biggest China-company IPO have been concentrated in financial services, real estate, food production, retail.

For China-investing PE firms, this means in most cases their portfolios are mismatched with what capital markets want. They hold stakes in thousands of Chinese industrial and manufacturing companies representing a total investment of over $20 billion in LP money.  For now, the money is trapped and time is growing short. PE fund life, of course, is finite. Many of these investments were made five to eight years ago. China PE need rather urgently to find a way to turn these investments into cash and return money to LPs. Here too the comparison with US private equity is especially instructive.

The colossus that is today’s US private equity industry, with 3,300 firms invested in 11,000 US companies, was built in part by doing successful buyouts in the 1980s and 1990s of manufacturing and industrial companies, often troubled ones. Deals like Blackstone‘s most successful investment of all time, chemicals company Celanese, together with American Axle and TRW Automotive, KKR‘s Amphenol Corporation, Bain‘s takeover of  Sealy Corporation and many, many others led the way. Meanwhile, smart corporate investors like Warren Buffett’s Berkshire Hathaway, Honeywell, Johnson Controls, Emerson Electric and were also pouring billions into acquiring and shaping up industrial businesses. So successful has this strategy been over the last 30 years, it can seem like there are no decent industrial or manufacturing companies left for US PEs to target.

Along the way, US PEs became experts at selecting, acquiring, fixing up and then exiting from industrial companies. US PEs have shown again and again they are good at rationalizing, consolidating, modernizing and systematizing industrial companies and entire industrial sectors. These are all things China’s manufacturing industry is crying out for. Market shares are fragmented, management systems often non-existent, inventory control and other tools of “lean manufacturing” often nowhere to be found.

So here’s a pathway forward for China PE, to use in China the identical investing skills honed in the US. It should be rather easy, since among the US’s 100 biggest private equity firms, the majority have sizeable operations now in China, including giants like Carlyle, Blackstone, KKR, TPG, Bain Capital, Warburg Pincus. For these firms, it should be no more complicated than the left hand following what the right hand is doing.

It isn’t working out that way. This is a big reason why China PE is performing poorly compared to the US. PE partners in China in the main came into the industry after getting an MBA in the US or UK, then getting a job on Wall Street or a consulting shop. Few have experience working in,  managing or restructuring industrial companies. They often, in my experience, look a little out of place walking a factory floor. This is the other big mismatch in China PE — between the skill-sets of those running the PE firms what’s needed to turn their portfolio companies into winners.

Roll-up, about the most basic and time-tested of all US PE money-making strategies, has yet to take root in China. Inhospitable terrain? No, to the contrary. But, it requires a fair bit of sweat and grit from PE firms.

This may account for the fact that China PE firms are now mainly herding together to try to close deals in e-commerce, healthcare services, mobile games and other places where no metal gets bashed. PE firms formed such a crush to try to invest in Xiaomi, the mobile phone brand, that they drove the valuation up in the latest round of funding to $46 billion, so high none of them decided to invest. China PE is that paradoxical – fewer deals are getting done, fewer have profitable exits and yet valuations are often much higher than anywhere else.

Another worrying sign: of the big successful China company IPOs in 2014 – Alibaba, Dalian Wanda‘s commercial real estate arm, CGN, CITIC Securities, Shaanxi Coal, JD.com, WH Group  – only one had large global PE firms inside as large shareholders. That was WH Group, a troubled deal that had a hard time IPOing and has since sunk rather sharply. For the big global PE firms, 2014 had no big China IPO successes, which is probably a first.

The giant US PEs (Blackstone, Carlyle, KKR, Goldman Sachs Capital Partners, Bain Capital, TPG and the others) all voyaged to China a decade or more ago with high hopes. Some even dared predict China would become as important and profitable a market for them as the US. They were able to raise billions at the start, build big teams, but it’s been getting noticeably harder both to raise money and notch big successful deals. And so their focus is shifting back to the US.

China has so much going for it as an investment destination, such an abundance of what the US lacks. High overall growth, a government rolling in cash, a burgeoning and rapidly prospering middle class, rampant entrepreneurship, huge new markets ripe for taking. Why then are so many of the world’s most professional and successful investors finding it so tough to make a buck here?

 

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

Leave a Comment / June 24, 2016

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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)
 
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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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Anti-Dumping or Blatant US Protectionism? How the US Tried and Failed to Destroy a Great Chinese Entrepreneur

Leave a Comment / May 6, 2013

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Reckless or evil? You decide. In July 2009, the US Department of Commerce started an anti-dumping investigation of the “narrow woven ribbon with woven selvedge” industry. Never heard of it?  It’s the colored ribbon Americans use primarily in gift-wrapping. It’s not a particularly big industry, probably less than $500 million a year in retail sales in the US. But, adding ribbon to gift-wrapped packages is a staple of American culture. The major store chains like Target, Wal-Mart, Michael’s and Costco all stock a wide variety of ribbon in different colors and widths, and sell it for a few dollars per pack.

Back when I was a kid, the ribbon was made by American manufacturers. Gradually, of course, much of the production shifted to Asia, first Taiwan, then China. Lowering manufacturing costs also kept retail prices down, which has likely allowed more Americans to use more ribbon to decorate their gifts.  Who could complain about that?

There remains one large American manufacturer called Berwick Offray, based in Pennsylvania. They’ve been in the woven ribbon business for over 100 years. They launched the complaint that led to the US government action, claiming they were suffering “material harm” because of Chinese ribbon being dumped in the US. According to the official document issued by the Department of Commerce in July 2009, the US government’s preliminary investigations seemed to confirm Berwick Offray’s contention that Chinese manufacturers were receiving state subsidies as a way to flood the US market and steal market share, harming Berwick’s business. The US government signaled its intention to levy punitive tariffs on the Chinese imports.

In its 142-page 2009 preliminary report, (click here to download) the Department of Commerce offers a feedlot of industry data, manufacturing techniques and product descriptions, all of which are aimed to substantiate the claim that Chinese manufacturers, who now hold the largest share of the US market, are selling the ribbon in the US below cost, with the loss being covered through a variety of unspecified subsidies from the Chinese government. Keep in mind that the total amount of US imports of woven ribbon from China seemed then to be below $100mn. A lot of market share data in the report was blacked out, presumably for commercial secrecy reasons. A lot of other information was absent because the Commerce investigators said they couldn’t find people willing or able to answer its questions.

So, the entire US federal government investigation, and preliminary finding of Chinese ribbon dumping was based both on incomplete data, and the dubious premise that the Chinese government would actively intervene with subsidies in such a small market. Total Chinese exports to the US in 2011 exceeded $400 billion. So, if the data is right, Chinese woven ribbon represents about 0.025% of total Chinese exports. The manufacturers are mainly privately-owned Chinese companies, not big SOEs with political clout in Beijing.

Among those Chinese manufacturers, one stands out for its scale, its variety of products and leading market share in the US. The company is called Yama Ribbon. They are based in Xiamen and dominate the industry in China. Yama is named in the Commerce Department report as one of the major exporters to the US. Since Yama is the biggest Chinese exporter, and the US government is suggesting Chinese government subsidies allow Chinese manufacturers to sell their ribbon below cost, it stands to reason that Yama should be fingered in the report as the main beneficiary of these subsidies. Right? The US government couldn’t possibly allege the Chinese government is subsidizing a product unless they’ve already confirmed the main Chinese producer is receiving such subsidies. Right?

Wrong. Trade policy, anti-dumping actions, punitive tariffs are very often a political toy in the US. Too often, US companies can use lobbyists or friendly politicians to pressure the Commerce Department to initiate an investigation. That alone can often cause exporters, whether they are dumping or not, to increase their prices, just to try to avoid any unilateral action by Washington. This, then, boosts the competitive position, and so the profits, of the US company that started the anti-dumping ball rolling. It isn’t called corruption, but often it should be understood as such.

Is this the case with Berwick Offray and woven ribbon? Did it use the US political process to help its foundering business in the US? That seems the case to me. Here’s why. After its initial report in 2009, the Commerce Department launched a more detailed analysis to identify all the subsidies Yama Ribbon and other Chinese manufacturers were receiving from the Chinese government.

In July 2010, the US officials announced they could find no evidence of Yama receiving any subsidies whatsoever. Yama Ribbon products were assigned an “anti-dumping” duty of 0%. It was a complete victory for Yama and a repudiation of misguided US protectionist trade policies. It received about zero press coverage, in China and the US, which is a shame.  Next time you hear someone spouting off about “unfair China trade practicies” or “predatory pricing”, think about Yama.

Several other Chinese manufacturers were found to be receiving subsidies, and their products were slapped with punitive duty rates of 125% to 249%. But, Yama is the main producer and exporter. If it’s receiving no subsidies, then it is impossible to claim the Chinese government is rigging the market to the detriment of Berwick Offray and the few other remaining US producers of woven ribbon.

How, you might ask, could the US government have even issued the preliminary 2009 report before establishing beyond doubt that Yama was getting favors from the Chinese government? The same question occurred to Yama’s founder and CEO, Yao Ming. (Yes, same name, but no relation to — physically or by bloodline –  to the Chinese basketball star.)  When he heard about the 2009 investigation and preliminary finding, Yao understood immediately it had the potential to damage, if not ruin his entire business, with 2011 revenues of over USD$50mn and over 1,000 employees. The US is his key market, over 70% of total turnover.

I’m fortunate enough to know Yao Ming. He’s a modest, hard-working entrepreneur, among the best I’ve ever met. My guess is as a businessman he could run circles around the people who manage Berwick Offray.  He’s not a political creature, speaks very little English, and until then, was unschooled in the ways of US trade policy. The US government was asserting Chinese ribbon exporters were getting subsidies and yet Yao knew he was receiving nothing. Knowing, and proving it to Washington, of course, are very different stories. He tried getting help from the Chinese Ministry of Commerce. But, they told him, effectively, he would have to fight this one on his own. They have bigger trade battles to wage with the US than this tiny one over gift ribbon.

So Yao hired lawyers, both in China and the US, and fought back. He’s the only Chinese entrepreneur I’ve heard about with this kind of character and self-confidence to spend a not-small amount of money to fight back against the US government. Even more remarkably, he won a resounding and speedy victory.

He more or less dared the US government to prove he was getting subsidies, including indirect ones like loan subsidies, special deals to buy factory land or tax holidays. When the US government couldn’t find a thing, it gave up pursuing Yama. Justice, in this case, was served. But, Yao was also lucky. His business is unusual in China. At that time, he has no bank loans, and his factories are rented. Both are rare among manufacturers in China. For any other manufacturer in China, it would be far harder to prove as quickly an absence of subsidies, direct or indirect. Yao needed to act, before the threat of an anti-dumping action permanently damaged his business in the US.

As an American citizen, I’m more than a little disgusted by what the US government did in this case: it made that 2009 announcement, declaring a preliminary finding, without really checking its facts. Had Yao not acted quickly, hired lawyers and proved his case, his business would have been sunk, and Americans would end up paying much more to decorate their gifts.

Had Commerce wanted to, it would have taken almost no time or effort to establish that Yama, as the largest Chinese ribbon exporter, was likely getting nothing from the Chinese government. But, they didn’t bother. That’s the worst of it. People at the Department of Commerce know how damaging an investigation and preliminary finding like this can be to any businesses implicated in wrongdoing.

In the end, from what I can tell, Commerce cared more about placating Berwick Offray than in making sure it didn’t unjustly harm a company faraway in China. Everything, in the end, has turned out well for Yao Ming and Yama. His business, including exports to the US, continue to thrive. He has some of the highest net margins I’ve seen in a Chinese manufacturing company. His revenues this year will approach USD$100mn. He has opened an office now in New Jersey to help handle all the orders. His Chinese competitors are now largely shut out of the US market because of the punitive duties. None seems to have had the scale or cash to hire lawyers and go to court in the US, as Yao Ming did. So whether these punitive duties are justified is, to me, an open question.

Yama’s business is number one in the US not because it sells product at the lowest price. It doesn’t. It has a better business model, thanks to the business smarts of its founder Yao Ming. He keeps a large stock of ribbon in a huge array of sizes and colors in inventory in the US, to meet spot orders. While it increases his costs, because of the extra working capital needed to finance the inventory, distributors and retailers can get orders filled more quickly. So, they buy from Yama. The company’s scale and service allow it now to earn margins that would be the envy of just about every other manufacturer operating in China.

Yao Ming is Chinese. But, he is the kind of Horatio Alger entrepreneur many in the US most admire. He makes a good product, sells it at a fair price, is good to his workers, and fought back against knuckle-headed Washington bureaucrats and won.

 

 

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

Leave a Comment / April 25, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

1 Comment / April 4, 2013

 

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

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

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

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

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

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

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

 

 

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

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

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

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

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

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

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

 

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

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

 

 

The “OTCBB-ization” of the Hong Kong Stock Exchange

Leave a Comment / March 6, 2012

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From the world’s leading IPO stock market to a grubby financial backwater with the sordid practices of America’s notorious OTCBB. Is this what’s to become of the Hong Kong Stock Exchange ?

I see some rather disturbing signs of this happening. Underwriters, with the pipeline of viable IPO deals drying up, are fanning out across China searching for mandates and making promises every bit as mendacious and self-serving as the rogues who steered so many Chinese companies to their doom on the US OTCBB.

The Hong Kong Stock Exchange (“HKSE”) may be going wrong because so much, until recently, was going right.  Thanks largely to a flood of IPO offerings by large Chinese companies, the HKSE overtook New York in 2009 to become the top capital market for new flotations. While the IPO markets turned sharply downward last year, and the amount of IPO capital raised in Hong Kong fell by half, the HKSE held onto the top spot in 2011. US IPO activity remains subdued, in part due to regulatory burdens and compliance costs heaped onto the IPO process in the US over the last decade.

During the boom years beginning around 2007, all underwriting firms bulked up by adding expensive staff in expensive Hong Kong. This includes global giants like Goldman Sachs, Citibank and Morgan Stanley, smaller Asian and European firms like DBS, Nomura, BNP Paribas and Deutsche Bank and the broking arms of giant Chinese financial firms CITIC, ICBC, CIIC, and Bank of China. The assumption among many market players was that the HKSE’s growth would continue to surge, thanks largely to Chinese listings, for years to come. With the US, Europe and Japan all in the economic and capital market doldrums, the investment banking flotilla came sailing into Hong Kong. Champagne corks popped. High-end Hong Kong property prices, already crazily out of synch with local buying power,  climbed still higher.

The underwriting business relies rather heavily on hype and boundless optimism to sell new securities. It’s little surprise, then, that IPO investment bankers should be prone to some irrational exuberance when it comes to evaluating their own career prospects. The grimmer reality was always starkly clear. For fundamental reasons visible to all but ignored by many, the flood of quality Chinese IPOs in Hong Kong was always certain to dry up. It has already begun to do so.

In 2006, the Chinese government closed the legal loophole that allowed many PRC companies to redomicile in Hong Kong, BVI or Cayman Islands. This, in turn, let them pursue IPOs outside China, principally in the US and Hong Kong. Every year, the number of PRC companies with this “offshore structure” and the scale and growth to qualify for an IPO in Hong Kong continues to decline. A domestic Chinese company cannot, in broad terms, have an IPO outside China.

Some clever lawyers came up with some legal fixes, including a legally-dubious structure called “Variable Interest Entity”, or VIE, to allow domestic Chinese companies to list abroad. But, last year, the Chinese Ministry of Commerce began moving to shut these down. The efficient, high-priced IPO machine for listing Chinese companies in Hong Kong is slowly, but surely, being starved of its fuel: good Chinese private companies, attractive to investors.

Yes, there still are non-Chinese companies like Italy’s Prada, Russia’s Rusal or Mongolia’s Erdenes Tavan Tolgoi still eager to list in Hong Kong. There is still a lot of capital, while listing and compliance costs are well below those in the US. But, the Hong Kong underwriting industry is staffed-up mainly to do Chinese IPOs. These guys don’t speak Russian or Mongolian.

So, the sorry situation today is that Hong Kong underwriters are overstuffed with overhead for a “coming boom” of Chinese IPOs that will almost certainly never arrive. China-focused Hong Kong investment bankers are beginning to show signs of growing desperation. Their jobs depend on winning mandates, as well as closing IPOs. To get business, the underwriters are resorting, at least in some cases, to behaviors that seem not that different from the corrupt world of OTCBB listing. This means making some patently false promises to Chinese companies about valuation levels they could achieve in an Hong Kong IPO.

The reality now is that valuation levels for most of the Chinese companies legally structured for IPO in Hong Kong are pathetically low. Valuations keep getting slashed to attract investors who still aren’t showing much interest. Underwriters are finding it hard to solicit buy offers for good Chinese companies at prices of six to eight times this year’s earnings. Some other deals now in the market and nowhere near close are being priced below four times this year’s net income. At those kind of prices, a HK IPO becomes some of the most expensive equity capital around.

In their pursuit of new mandates, however, these Hong Kong underwriters will rarely share this information with Chinese bosses. Instead, they bring with them handsomely-bound bilingual IPO prospectuses for past deals and suggest that valuation levels will go back into double digits in the second half of this year. In other words, the pitch is, “don’t look at today’s reality, focus instead at yesterday’s outcomes and my rosy forecast about tomorrow’s”.

This is the same script used by the advisors who peddled the OTCBB listings that damaged or destroyed so many Chinese companies over the last five years. Another similar tactic used both by OTCBB rogues and HK underwriters is to pray on fear. They suggest to Chinese bosses that they should protect their fortune by listing their company offshore, at whatever price possible and using whatever legally dubious method is available. They also play up the fact a Chinese company theoretically can go public in Hong Kong whenever it likes, rather than wait in an IPO queue of uncertain length and duration, as is true in China.

In other words, the discussion concerns just about everything of importance except the fact that valuation levels in Hong Kong are awful, and there is a decent probability a Chinese company’s HK IPO will fail. This is particularly the case for Chinese companies with less than USD$25 million in net income. The cost to a Chinese company of a failed IPO is a lot of wasted time, at least a million dollars in legal and accounting bills as well as a stained reputation.

There is, increasingly, a negative selection bias. Investors rightly wonder about the quality of Chinese companies, particularly smaller ones, being brought to market by underwriters in Hong Kong.

“No one has a crystal ball”, is how one Hong Kong underwriter, a managing director who spends most of his time in China scouring for mandates, explains the big gap between promises made to Chinese bosses, and the sad reality that many then encounter. In a real sense, this is on par with him saying “I’ve got to do whatever I’ve got to do to earn a living”. He can hold onto his job for now by bringing in new mandates, then hope markets will turn around at some point, the valuation tide will rise, and these boats will lift. This too is a business strategy used for many years by the OTCBB advisor crowd.

The OTCBB racket is now basically shut down. Those who profited from it are now looking for work or looking elsewhere for victims, er mandates. Tiny cleantech deals are apparently now hot.

My prediction is a similar retrenchment is on the way in Hong Kong, only this time those being retrenched won’t be fast-buck types from law firms and tiny OTCBB investment banks no one has heard of. Instead, it’ll be bankers with big salaries working at well-known brokerage companies. The pool of IPO fees isn’t big enough to feed them all now. And, that pool is likely going to evaporate further, as fewer Chinese companies sign on for Hong Kong listings and successfully close deals.

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Sino-American Relations – Some Overblown Analysis from the USA

Leave a Comment / February 4, 2010

Ge Vase from China First Capital blog post

Is China’s reaction to last week’s announced US arms sale to Taiwan really all that more strident than in the past? Should America be worried? To read some of the recent American news reporting, citing the usual ragbag of US-based “China experts”, you might conclude so.

http://www.washingtonpost.com/wp-dyn/content/article/2010/01/30/AR2010013002443.html
 http://www.nytimes.com/2010/02/01/world/asia/01china.html?scp=1&sq=helene%20cooper&st=cse

I don’t buy it. China is not set, contrary to such reports, firmly on a course to antagonize America. It is, however, a great power with legitimate national interests to assert and protect. Sometimes those will clash with America’s national interests. But, the bilateral relationship also has a root system of common goals and shared admiration. 

I also don’t buy the line by American “China experts” about rising Chinese “triumphalism” , due to continued strength of Chinese economy. China’s economy has been outgrowing the US by eight to ten percentage points just about every year for the last 30 years. Same was true in 2009. The only difference: China grew by 8% while the US economy shrunk by over 5%. A similar net result as in the past, but one that highlighted a dramatic lessening of China’s economic dependence on the US. 

Do Chinese officials realize they now can maintain high economic growth without single-minded focus on exports to US, but look to domestic market instead? Yes. But, as you’ve also read, from Premier Wen Jiabao on down, there’s frequent public declarations on all the many problems and inefficiencies in China’s economy. 

Yes, China is getting stronger every year in every respect. But, is the tone now on arms sales to Taiwan really all that different? I don’t see it, and wonder how much others here see it, or whether it’s just the usual conventional US wisdom on China, a cousin of the “China expert” analysis that Chinese economic growth is a fraud, only resulting from cooked gdp numbers. 

China is mainly busy being China, just as America, most of the time is also mainly busy being America.  Both are continental powers with huge populations and vast domestic markets. Both also have a long history of being more inward- than outward-looking, quite patriotic, even occasionally xenophobic.

They often view the world with a similar sense of aloof distrust. There will always be points of friction between the US and China. But, time is gradually wearing down those points of friction, not sharpening them, as much of the US press would have us believe.

 

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

2 Comments / October 31, 2009

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.

Field Report from Guizhou – Where Cement Turns Into Gold

Leave a Comment / October 31, 2009

Blue vase in China First Capital blog post

 

While writing this, I was more than a little the worse for drink. Over dinner, I drained the better part of a bottle-and-a-half of Maotai, China’s most celebrated rock-gut spirit, which sells for a price in China that French brandy would envy, upwards of $80 a bottle. It’s one of the more pleasant occupational hazards of life in China for a company boss. As far as I can tell, some Chinese seems to view it as a matter both of national pride and infernal curiosity to get a Western visitor plastered. By now, I know well the routine. I sit at a table surrounded by people generally drawn together with a common purpose – to treat me solicitously while proposing enough toasts to render me wobbly and insensate.  

As far as career liabilities go, this is one I can happily live with. I always try to eat my way to relative sobriety.  I’m in Guizhou Province. (I’ll wait five minutes while most readers consult an online atlas.) The food here is especially yummy – intense, concentrated flavors, whether it’s a chicken broth (I’m informed it’s so good because local chickens have harder bones than elsewhere in China), pig ear soup, a simple stir-fried cabbage, or a dizzily delicious dish of corn kernels from cobs gathered nearby. So, with each glass of Maotai (which started as thimble-sized and then were upgraded to proper shot-glasses) I tried as best as I could to wolf down enough solid material to hold at bay the nastier demons of drunkenness. 

Did I succeed? I believe so. At least in part. My Chinese didn’t sputter and seize up like a spent diesel engine, and my brain could just about keep up with the typhoon of sounds, smells and data points of the humongous cement factory I toured after dinner. 

If you can find a way to get to Eastern Guizhou, or Western Hunan, do. You’ll likely travel, as I did, along an otherwise empty but fantastically beautiful motorway, past the squat two-stored dwellings of the local Miao people, and the inspiringly eroded prongs that make up the local mountain-scape. If you are even luckier, and share my peculiar taste of what constitutes an ideal weekend, you might just end up, as I did, at the largest private cement company in Guizhou. It’s called Ketelin, and it’s to capitalism what a Titian portrait is to fine arts: drop-dead gorgeous. 

With Maotai bottles drained, and dinner inhaled, I went on a walking tour of the Ketelin factory, on a warm, breezy and clear summer night unlike any I’ve ever witnessed lately in smoldering Shenzhen and Shanghai. My host here is the company’s founder and owner, 宁总, aka Ning Zong. If I had to specify a single rule to determine how to discern a great entrepreneur, it might be “his favorite form of exercise is to walk 20 laps around his humming factory every night after dinner.” Such is the case with Ning Zong. Another great indicator, of course, is to have a business where customers are lined up outside your door, 24 hours a day, waiting to buy your product. That’s also true here. There is a queue of large trucks outside the front gate at all hours, waiting to be filled with Ketelin cement.  

Ning Zong is out here, in what is considered the Chinese “back-of-the-beyond”, and has built the largest private company in the province. And that’s just for starters. His only goal at this point is to build his company to a scale where it can serve all its potential customers, with the highest-quality cement in this part of China. This being China, that’s a very substantial, though achievable vision. He’s already built a state-of-the-art factory, on a scale that few can match anywhere else. And yet, there’s still so much unmet demand, not just in Guizhou, but in nearby provinces of Sichuan, Hunan and Hubei that Ning Zong’s burning desire, at this phase, is to expand his business by several-fold. 

That’s why I’m here, to work with him to find the best way to do so, by bringing in around $15 million in private equity. I have no doubt whatsoever that his plans and track record will prove a perfect match for one of the better PE firms investing in China. Whichever one of them gets to invest in Ketelin will be very fortunate. This facility, and this owner, are both pitchforks perfectly tuned to the key of making good money from the boom in China’s infrastructure development. Among other customers, Ketelin supplies cement to the big highway-construction projects underway in this area of China. 

 Is Ketelin an exception, here in Guizhou?  I don’t really have the capacity to answer that. Guizhou is generally considered by Chinese to be the also-ran in China’s economic derby, poorer, more hidebound and more geographically-disadvantaged than elsewhere in southern China. Water buffalo amble along the middle of local thoroughfares, and field work is still done largely without machines, backs stooping under the weight of newly-gathered kindling. While Guizhou is poor compared to neighboring Hunan and Sichuan, poor regions often produce some of the world’s best companies:  think of Wal-Mart and Tyson’s, both of which got started and are based in Arkansas, which is as close as the US has to a province like Guizhou.  

Guizhou, from what I’ve seen of it, is breath-takingly beautiful, with clean air and little of the ceaseless hubbub that marks the cadence in big cities like Shenzhen and Shanghai. This is China’s true hinterland, the part of this vast country that eminent outsiders have long said was impossibly backward and so beyond the reach of modern development.  

They are wrong, because what’s right here is the same thing that has already generated such stupendous growth in coastal China. It’s the nexus of vision and opportunity, of seeing how much money there is to be made and then doing something about it, to claim some of that opportunity and money as your own. Ning Zong has done so, on a scale that inspires awe in my otherwise Maotai-mangled mind. 

Come see for yourself.

 

Most Thankless Well-Paid Job in China: Market Forecaster

Leave a Comment / August 14, 2009

Calligraphy from China First Capital blog post

 

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

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

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

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

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

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

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

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

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

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

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

 

 

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China Zigs While the Rest of the PE and VC World Zags

Leave a Comment / September 10, 2009

Tang vase from China First Capital blog post

This is a time of darkness and despair for most private equity and venture capital guys. Their world came crumbling down last year, as credit and stock markets collapsed and IPO activity came to a halt everywhere —  everywhere that is, except China.  

If ever there were an example of a counter-cyclical trend, it is the private equity industry in China. It is poised now for the most active period, over the next 12 months, in its young history. There are many reasons to explain why China should be so insulated from the deep freeze that’s gripping the industry elsewhere. For one thing, it has always relied less on leverage, and more on plain vanilla equity investing. 

This mattered crucially, since as credit markets seized up last year, PE firms were still able to do deals in China, by putting their own equity to work. Of course, PE firms in the US could have done the same thing. After all, most have very large piles of equity capital raised from limited partners. But, they have habituated themselves to a different form of investing, involving tiny slivers of equity and very large slabs of bank debt. Like any leveraged transaction, it can produce phenomenal results, on a return-on-equity basis. But, without access to the debt component, many PE firms seem adrift. It’s as if they’ve forgotten, or lost the knack of how to properly evaluate a company, to look at cash flows not in relation to potential debt service, but as a telltale sign of overall operating performance. 

Many PE firms these days seem to resemble a hedge fund gone bad:  they once had a formula for making great piles of money. Then, markets changed, the formula stopped working, and the firms are at a loss as to how to proceed. 

China looks very different. Beyond the lack of leverage, there are other, larger factors at work that are the envy of the rest of the PE world. Most importantly, China’s economy remains robust. It’s done a remarkable pirouette, while the rest of the world was falling flat on its face. An economy dependent until recently on exports is now chugging along based on domestic demand. And no, it’s not simply — or even mainly —  because of China’s huge +$600 billion stimulus package. The growth is also fueled by Chinese consumers, who are continuing to spend. 

There’s one other key factor, in my opinion, that sets China apart and makes it the most dynamic and desirable market for PE investing in the world: the rise of world-class private companies, of a sufficient scale and market presence to grow into billion-dollar companies. In other words, PE investing in China is not an exercise in financial engineering. It’s straight-up equity investing into very solid businesses, with very bright futures. 

One common characteristic of PE investing in China, all but absent in the US, is that the first round of equity investment going into a company is smaller than trailing revenues. So, in a typical deal, $10mn will be invested into a company with $50 million of last year’s revenues, and profits of around $5 million. Risk mitigation doesn’t get much better than this: investing into established, profitable companies that are often already market leaders — and doing so at reasonable price-earnings multiples. 

China has other things going for it, from the perspective of PE investors: the IPO window is open; dollar-based investors have the likely prospect of upping their gains through Renminbi appreciation; management and financial systems both have significant room for improvement with a little coaching from a good PE firm. 

It all adds up to a unique set of circumstances for PE investors in China.  It’s a highly positive picture all but unrecognizable to PE and VC firms in the US and elsewhere. Opportunities abound. Risk-adjusted returns in China are higher, I’d argue, than anywhere else in the world. A +300% return over three to five years is a realistic target for most PE investment in China. The PE firms invest at eight times last year’s earnings, and should exit at IPO at 15 times, at a minimum. Pick the right company (and it’s not all that difficult to do so), and the capital will be used efficiently enough to double profits over  the term, between the PE investment and the IPO.  Couple these two forces together — valuation differentials and decent rates of return on invested capital — and the 300% return should becomes a modest target as well as reasonably commonplace occurrence. 

It’s  the kind of return some US PE firms were able to earn during the good years, but only by layering in a lot of bank debt on top of smaller amounts of equity. That model may still work, at some future time when banks again start lending at modest interest rates on deals like this. But, there’s an inherent instability in this highly-leveraged approach: cash flows are stretched to the limit to make debt payments. A bad quarter or two leads to missed repayments, and the whole elaborate structure crumbles: just think of Cerberus’s $7.5 billion purchase of 80% of Chrysler. 

China is in a world of its own, when it comes to PE investing. My best guess is that it remains the world’s best market for PE investment over the next ten years at least. Little wonder that many of the world’s under- or unemployed PE staff members are taking crash courses in Chinese. 

Here’s one of the slides from the PPT that accompanied a recent talk I gave  in Shanghai called “Trends in Global Private Equity: China as Number One”.

Private Equity in China  中国的私募股权投资: 

—Strong present, stronger future—  今天不差钱，明天更美好

—PE firms continue to raise money for investment in China, over $10 billion in committed   capital and growing —  私募股权基金仍在继续募集资金投资国内，规模已经为100亿美元并将继续增长

—Next 12 months : most active in history ; IPO window open; finding and financing China’s next national champions —  未来的一年：历史上最蓬勃发展的时期，IPO 重启，发现并投资中国下一批的企业明星

 

For whole presentation, please click: 私募股权投资：中国成为第一 

 


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Shenzhen’s New Small-Cap Stock Market — A Faster Path to IPO. Not Always a Smarter Path

Leave a Comment / July 23, 2009

lichi painting from blog post by China First Capital

One of the main themes of the PE conference I attended last week in Shanghai was the launch of the Shenzhen Stock Exchange’s new Growth Enterprise Market “GEM”, for smaller-cap, mainly high-tech companies.

It’s been a long time in the planning – since at least 1999. In March 2008, China’s Prime Minister, Wen Jiabao, tried to kickstart the process and announced plans to open soon this second market in Shenzhen. Events then intruded – the credit crisis struck, financial markets tanked, and so plans for China’s GEM went into limbo.

Things are now back on track. Trading is likely to begin in October. At the conference, most of the speakers focused on hows and whys the GEM would open new opportunities for smaller companies to raise money from China’s capital market.

Overall, it’s a development I applaud. Private companies in China are often starved of growth capital, and the GEM will mean more of the country’s capital gets allocated to these businesses.

There is one aspect, however, of the GEM that I personally find a little less positive. It’s a small quibble, but my concern is that the opening of the GEM will lead still more Chinese companies to divert time and resources away from building their profits and market share and instead devote energy and cash towards going public. The smaller the company, the more potentially harmful this diversion of attention can be.

China is, to use a military analogy, a “target-rich environment”. Companies often have more opportunities than they have time or resources. This is the product of an economy growing very strongly (8% this year) and modernizing at lightning speed. Large companies can also suffer when they shift focus from gaining customers to gaining a public listing. But, they will usually operate in an established market with established customers. This gives them more of a cushion.

Smaller, high-tech companies don’t have as much leeway. For these companies (last year’s revenues under $5o million) the risk is that the time-consuming and expensive process of planning an IPO on GEM will severely impact current operations, causing it to miss chances to expand, and so lose out to better-focused competitors.

In other words, there’s a trade-off here that tends to get overlooked in all the excitement about the opening of this new stock market in China. The trade-off is between focusing on capital-raising and focusing on building your business.

In my experience, private Chinese companies are already often a little too fixated on an IPO. It’s the main reason so many have made the poor, and often fatal, choice to go public on the American OTCBB. The GEM, I fear, will add fuel to this fire. Often, the best choice for a fast-growing private Chinese company will be to ignore the many pitches they’ll hear from advisors to IPO, and hunker down by focusing on their business for the next year or two.

Yes, being a boot-strapped company is tough. There’s never enough cash around. I know this at first-hand, since along with running China First Capital, I’m also CEO of a boot-strapped security software company in California, Awareness Technologies. Our growth opportunities far exceed our ability to finance them. So, I can understand why the thought of raising an “easy” $5 million – $15 million by going public on the GEM is very attractive to any Chinese boss running a similar cash-short and opportunity-rich company.

But, capital always has a cost. In this case, the main costs will be both the cash paid to advisors and regulators, along with the indirect cost of being a beat slower to seize available opportunities to grow. In China at the moment, any slowness is not just a problem. It can be life-threatening. Every business here operates in a hyper-competitive marketplace.

Of course, any company that can raise money by going public on the GEM will eventually enjoy a big advantage over competitors. It will have the cash and the stronger balance sheet to finance growth. But, the IPO process in China remains far slower than in the US or Hong Kong. A company planning and funding its GEM IPO now, may need to wait two years or more to get all necessary approvals and so finally raise that money with an IPO. Meantime, competitors are, as Americans like to say, eating this company’s lunch.

It’s a discussion we often have with SME bosses – how to time optimally an IPO. A rule of thumb with IPOs is: “small is not beautiful.” Going public on the strength of still limited earnings and revenues will likely result in a small market cap. This can adversely affect share price performance, and so limit the company’s ability to raise additional equity capital. To avoid this trap, it’s often going to be better to wait. Let competitors get bogged down in IPO planning. You can then grow at their expense.

In one way, though, the establishment of the GEM market is an unqualified triumph. It sends the signal far and wide that private SME companies will play an ever larger role in fueling the growth of China’s economy.

 

 

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In Global Private Equity, It’s China as #1

Leave a Comment / July 21, 2009

Qing ceremonial ruyi in China First Capital blog post

 

I spent the day in Shanghai on Friday, attending a private equity conference, and giving one of the keynote speeches. I’d thought about giving my talk in Chinese, but in the end, the discretion/valor calculus was too strong in favor of using my native language. I was one of only two speakers who used English — or in my case, a kind of half-bred version of miscegenated Mandarin and English. The rest of the conference participants — including two other Westerners and dozens who participated in panels – all spoke in Chinese.  It was quite humbling, and I’m determined to use only Chinese next time around. 

Shanghai has, so rapidly, become a truly international city. It’s one thing to say, as Shanghai’s leadership has been doing over the last decade, that Shanghai will surpass Hong Kong as Asia’s largest, most vibrant international financial center. It’s quite another to achieve this, or even make significant headway, as Shanghai has done. So many of the factors aren’t under the control of government authorities. They can only create the legal and tax framework. In the end, the process is driven by individual decisions made by thousands of people, who commit to learning English and mastering the basics of global finance. All are staking their careers, at this point, on Shanghai’s future as a financial center. 

It’s a version of what economists like to call “network effects”: the more individuals who commit to building Shanghai as a financial center, the more each benefits as the goal comes closer to fruition. On Friday, in Shanghai, I could see this process vividly displayed in front of me, of how widespread knowledge of English has become: of the 200 or so people who heard my talk, at a glance 99% were Chinese, and only a handful needed to use the translation machines.

My talk was titled “Trends in Private Equity: China as #1”.  In Chinese, it’s “私募股权投资：中国成为第一”

The basic theme was how “decoupled” China has become from private equity and venture capital investment in the rest of the world.  China is in the ascendant, and will remain that way, in my opinion, for the next ten years at least. It will be years before the PE and VC industries in the US reach again the size and significance they enjoyed a year ago. China, meanwhile, is firing on all cylinders.

There are many reasons for China’s superior current performance and future prospects. In my talk, I focused on just a few, including principally the rise over the last decade of a large number of outstanding private SME. They are now reaching the scale to raise successfully private equity and venture capital funding.

It’s another example of positive network effects: the Chinese economy is undergoing a shift of breathtaking significance: from dependence on the public sector to reliance on the private sector, or in my shorthand, “from SOE to SME”. The more successful SME there are, the more embedded this change becomes, and the more favorable overall circumstances become for newer SME to flourish. 

Here’s one of the slides from my PPT that accompanied the talk: 

—  Global Private Equity: in trouble everywhere except China
 全球私募股权投资：除了中国以外的其它市场都陷入困境

—  Recession; Credit Crisis; Over-leveraged ; closing IPO window

—  经济衰退，信贷危机，杠杆率过高，几近停止的IPO

—  Most PE firms dormant, can’t raise new equity or new debt; industry contracting

—  PE公司无法进行股权和债权融资，几乎处于休眠状态，行业萎缩

—  China is the exception:  strong economic fundamentals; shift from export to domestic market;  shift from state-owned to private sector;  rise of world-class SME

—  中国的独特之处：强劲的经济增长，从出口导向到关注国内市场的转变，经济从国有企业到私营企业的迁移， 富有成为世界级企业潜力的中小企业

 For anyone interested, the whole speech is available, in Chinese, at http://news2.eastmoney.com/090717,1117,1134998.html

 

 

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