valuation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

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

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.

CFC’s New Research Report, Assessing Some Key Differences in IPO Markets for Chinese Companies

China First Capital research report cover

For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

  1. Valuation, p/e multiples
  2. IPO approval process – cost and timing of planning an IPO
  3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.


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

Ming Dynasty flask, from China Private Equity blog post

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

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

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

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

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

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

chart1









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

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

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

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

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

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

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

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

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


Requiem For A Tough Year – 2008 Was the Most Challenging Time in a Generation in China

tang-bowls

As the Chinese National Congress meets this week in Beijing to plot the course of the Chinese economy in 2009 and beyond, it’s worth reflecting what an exceptional, juddering year 2008 was. Sure, the Olympics stole most of the headlines, and provided the lasting images of Chinese progress and triumph. But, those images also dulled, in many respects, our perceptions of the brunt force of the economic blows China sustained during 2008. Make no mistake, 2008 was a year of challenge, disruption and dislocation not seen in China for a generation or more. 

The year started with the worst winder storms in decades. This was followed, just months later, by the cataclysmic Wenchuan Earthquake in Sichuan. Beyond the colossal loss of life and destruction, the earthquake had a much broader, unprecedented social impact across China. There was an enormous outpouring of national compassion and grief. While wholly positive as an expression of China’s rightful growing self-confidence, this vast prolonged period of national mourning also had a very direct and negative impact on economic activity. For weeks if not months, as I saw firsthand, there was a tangible unwillingness to spend as freely, to enjoy life as unabashedly as in the years previously. It was as if much of China received some intimation of their own mortality in the wake of the Sichuan Earthquake. 

Next came an accelerated fall in property values across much of China. Alongside this, the stock market fell sharply. These two, the property and stock markets, are the main stores of wealth for many middle class Chinese. People felt poorer because they were poorer. The fall of both property and share prices wiped away billions of dollars in national household wealth. People in their hundreds of millions were suddenly poorer, as household net worth plummeted, and Chinese pulled back even more strongly from their spending. Then, in late summer, came the financial tsunami in the USA, with the credit crisis, the collapse of Lehman Brothers, and the intensifying recession. 

Any basic college economics textbook – to say nothing of common sense — could foretell the next step: a fall in overall confidence levels among Chinese consumers. This further muffled already depressed levels of personal spending. 

We’re now well into the first quarter of 2009, and my own sense, after spending these last three weeks in China, is that the cumulative impact of all of 2008’s bad news is still being felt, acutely. However, my sense is that the worst may indeed be over, and that 2009 will be a year of rebuilding and reasserted economic confidence in China. 

Of course, when talking about general economic trends in the world’s third largest economy, a lot of the clarifying detail gets lost. But, we have a real sense, in our day-to-day work, of just what an extraordinarily difficult year 2008 was for even the best Chinese businesses. Our firm, China First Capital,  has focused on serving China’s middle market private Small and Medium Enterprises (SMEs), assisting them with capital-raising strategic M&A and other financial transactions.

Unlike traditional investment banks reliant mainly on short-term transactions, China First Capital’s role as financial and strategic advisor to Chinese SMEs often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Even our strongest clients had a tough time in 2008. In one example, a business that is one of China’s leading consumer fashion brand, maintained outstanding growth last year in overall revenue, with domestic sales rising by 30%.  That’s mainly testament to the company’s no less outstanding management and brand-positioning. But, the bottom line was less stellar. Profit margins were squeezed, and the company earned half as much in 2008 as it expected to as late as July 2008. That represents a shortfall against plan of almost $6mn. That equates, of course, to having less money to invest in building on that growth rate in 2009.  

They remain a great company, and there’s little doubt 2009 will be a better year. But, when we met with them recently, the company’s financial management are still reeling from the brutal effects of 2008. If nothing else, it drives home as little else can the importance of fortifying the company’s balance sheet, which has been overly-reliant on retained earnings and short-term bank loans to finance growth. This client, like the Chinese economy, has weathered the once-in-a-generation turmoil of 2008. Better days lie ahead — my bet is sooner, rather than later.  

Stairway to Hell? IPO Activity in China Falls Off a Cliff

 

Not quite “a staircase to hell”, but the graphic below shows the steep fall in IPO activity in China in 2008. It looks pretty scary, doesn’t it? Chinese IPO activity in 2008 was at its lowest level since 2004. IPO activity basically came to a halt towards the end of last year. 

cfn6461

No one looking at the table will see much room for optimism. But, it’s worth remembering that though down by almost 80% from the year earlier, IPOs of Chinese companies in 2008 still did manage to raise $20 billion of new capital. The key thing now is that this money is used well and wisely, to build profits and market share at these now-publicly-traded Chinese companies. By doing so, these companies will provide an impetus for companies and investors to get back into the IPO market. 

In other words, the IPO market in China is most attractive vibrant not when a company sees a big price jump in its first days of trading. This does little for company, and benefits mainly those who claimed an allocation of shares ahead of the IPO. The key driver for the IPO market should be that the capital raised in an IPO is used wisely, to put companies on a higher growth path. 

Higher profits will boost company valuation, and also allow newly-listed companies to more easily raise additional equity capital in the future. As I sometimes remind the Chinese laoban we work with, “an IPO should not be just a goal in itself, but also the cheapest way to raise additional capital to build your business even faster.” 

Take the money from a public listing to make more money: that’s the quickest way in which Chinese companies can do their part for reviving the IPO market and start building again the “staircase to heaven”, with annual gains every year in the amount of money raised through IPOs. 

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Valuations head down in Chinese Private Equity — but too low is as bad as too high

How much is an asset worth? When the asset is a Private Equity stake in a high-growth private Chinese company, it’s as much a question of timing and sentiment, as underlying value. 

It’s clear as 2008 ends that the steep falls in world stock markets this year are causing a general reappraisal of valuation multiples in PE deals in China. This is logical, and inevitable. 

It’s logical, because entry and exit multiples can’t be completely decoupled. When share markets fall, so do price-equity multiples for most public companies. Their unquoted peers should track downward also.

The element of inevitability is that in many instances, the multiples on some PE investments in China had reached unsustainably high levels. How high? That depends who you ask. To me, if the multiple exceeds ten times trailing earnings, for a company in anything but exceptional cases in the high-tech or healthcare sectors,  the price is too high. 

PE firms chased valuations up. Now, they are chasing them down.

As recently as this spring, there were still investments being made in China at multiples of 12 times or higher. It’s hard to imagine those same deals being done now at anything like that price. 

Usually, the high multiples were the outcome of a bidding war, where several PE firms were competing for the chance to invest in a Chinese company. I’m all in favor of this, that PE firms should compete for good opportunities. Like any competitive bidding process, it results in a fairer price to the seller. 

That’s a primary responsibility we have at China First Capital, to get our clients the highest valuation from the most suitable potential investor. Both are important: price and the firm doing the investing.                    

But, while a competitive market is a good thing, the high-altitude double-digit valuations are not. They create, at the very least, additional and unwanted pressure, post-investment, on companies to pursue growth at all costs. This is the only way a PE firm could hope to make a decent return. 

The more malign effect, in my view, is that they give false signals to the market: specifically, they can create valuation expectations among other laoban that are unrealistic and unattainable. This can then delay or even eliminate the possibility of these firms raising the PE funding they will need. That is in no one’s interest.

I met this past week with a couple of very smart, seasoned PE investors in Shanghai. All are expecting a more active period of investing ahead as the New Year begins, after several months of greatly reduced deal flow. They are also, of course, expecting lower valuations than were the case earlier this year.

As we all know, markets have a tendency to overshoot. I sense, perhaps, that the PEs are looking now for valuations that are as unrealistically low as they were unrealistically high just a few months back. 

This is a problem almost as severe as overly-high valuation expectations among companies. Low ball valuations (by which I mean low to mid- single digits) are only going to appeal to companies that have no other financing options, or who foresee problems ahead in their business – problems they will try to keep hidden from a potential PE investor. In other words, a company that would take money at three times last year’s earnings is probably one best left to its own devices. 

Infinite Opportunities ÷ Finite Capital

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery. 

DD Done Right

Due diligence is rarely anyone’s idea of fun and games. Nor should it be. And yet, several days into the process now I’m struck just how positive the process can be, when it’s done right, done well, done in an atmosphere of shared goals and shared respect. At its best, DD sets the tone for a long period of successful partnership and value-creation between a company and an investor. 

This week, DD kicked off between one of our China First Capital clients and the Private Equity firm intending to invest in the company’s first round of equity finance. The PE firm is among the best, and it operates with the precision of a Geneva watchmaker. The DD checklists sent in advance were exhaustive, prepared both in Chinese and English, encompassing legal, financial and managerial topics. 

Our client – after recovering from the initial shock on seeing the sheer volume of information to be collected and presented – dug in and worked until late each night over the weekend to get the material ready.  The laoban struck exactly the right note from the beginning, explaining to his sometimes-beleaguered staff, that the volume of DD material was conclusive proof that this PE firm would make a professional, highly-competent and valuable partner if the deal closes. 

In other words, it’s a step in a process of increased transparency, meticulousness and accuracy. This will benefit the company immediately, in its operations and planning, and ultimately put it in a far stronger position as it moves toward a successful public listing down the road.   

We insist to our clients that they embrace this approach:  “even as a private company, you should adopt the standards of a public one.” This makes the transition to a publicly-traded company, accountable to both to regulators and shareholders, infinitely smoother.  It’s also just good business. 

On Monday, the PE firm’s DD team arrived at our client’s office, and set right to work. The highest standards clearly pervade all aspects of the PE firm’s operation, from the team — led by a woman of uncommon intelligence, poise and grace —  to the lawyers and Big Four accountants chosen to assist. 

They set the right mood from the outset: one of professional collaboration and partnership, rather than of abrasive investigation. In two days of highly-focused scrutiny, with lawyers, accountants and the PE firm’s team working on parallel tracks, the investor got an enormous amount of its preliminary due diligence completed. On Day Three, they headed out to visit the client’s factory in a neighboring province. 

It’s an old truism of PE and VC investing that the one certainty of the DD process is that there will be surprises, generally of an unwelcome variety. The real question is how large are the surprises and how well they are addressed, by both PE firm and the target company. 

I have confidence that in this case, the DD process will continue in a spirit of shared purpose and reciprocal transparency. As a result, I foresee a great outcome for both our client and this PE investor.