Ask people in China to name the country’s most successful and innovative new mobile phone brand and most will immediately declare Xiaomi. Ask tech-savvy Americans and Europeans and they will just as quickly suggest OnePlus. Though largely still unknown in China, Shenzhen-headquartered OnePlus, established less than 18 months ago, has achieved more success more quickly in US and European markets than any other Chinese mobile phone company. It is also possibly the China’s most successful startup since Xiaomi was established five years ago.
OnePlus, by my estimate, has now joined the most exclusive club in the technology world, a “unicorn”, meaning technology startups with a valuation of over $1 billion. Other Chinese unicorns besides Xiaomi are China’s Uber, Kuaidi Dache and group buying site Meituan. Unlike those other Chinese companies, OnePlus has not yet raised any money from venture capitalists. OnePlus is also the only truly international Chinese unicorn, since most of its sales and growth are outside China.
With just a tiny amount of seed capital, the company began selling its phones little more than a year ago in late April 2014. Its 2014 full-year revenues were $300mn, well behind Xiaomi’s $12 billion. But, unlike Xiaomi, OnePlus chose to focus its efforts on the US, Western Europe and India. In these places, OnePlus is doing far better than Xiaomi, and is now considered a legitimate competitor to major international Android phone brands like Korea’s Samsung, Taiwan’s HTC, Japan’s Sony and America’s Google Nexus. OnePlus is cheaper than these others, but that doesn’t seem to be the main reason its winning customers as well as enthusiastic reviews from experts. It’s mainly because of the quality of both OnePlus’s hardware and Android software.
According to the Wall Street Journal, the One Plus phone is “exceptional” and it “beats Apple iPhone 6 and Samsung Galaxy S5 in many ways.” The New York Times has called the OnePlus phone “fantastic, about the fastest Android phone you can buy, and its screen is stunning “. Time Magazine chimed in with OnePlus is “exactly how a smartphone should be.” Engadget, the widely-read US technology blog, recently rated the best phones to buy in the US. Oneplus came out on top. That’s certainly a first for a Chinese brand.
In my seven years as an investment banker in China and before that as CEO of a California venture capital firm, I’ve never met quite such a mold-breaking company. OnePlus set out to achieve what no other Chinese company has ever done, to excel not just at making low-cost fast-to-market products but making ones of the highest quality, in engineering and design, hardware and software.
They next did something else no Chinese, and few American companies have done successfully: use social media sites Twitter, Facebook and Youtube to market its products at almost zero cost, and build a brand with a high reputation and a growing band of loyal customers and followers in the US and European markets.
Both Xiaomi and OnePlus say they plan to make most of their money from selling services and software, not from selling phones. Xiaomi has the advantage of much larger scale, with far more users. But, OnePlus may actually do better with this strategy and make more money for the simple reason that in the US and Europe, compared to China, a lot of people are accustomed to paying for mobile software and services.
OnePlus sold over one million phones last year between May and December, mainly in the US and Europe. It spent a total of about $10,000 on advertising worldwide. Samsung, by contrast, spends over $350mn a year in the US advertising its mobile phones. Worldwide, Samsung is spending over $14bn in advertising and its mobile phone market share has been declining since 2013.
On many fundamental levels, OnePlus thinks and acts differently than any other successful startup in China. Start with its two founders, Pete Lau and Carl Pei. They met while working at a Chinese domestic mobile phone and Blu-ray player manufacturer called Oppo. Lau is responsible for OnePlus’s manufacturing and product engineering, including overseeing a network of outsourced suppliers and manufacturers in and around Shenzhen. “We want to tell the world: Chinese products are great,” Lau says.
Pei’s background is more unusual. He is responsible for the company’s international growth and unique marketing strategy. Everything about Pei – his background, his way of thinking and his approach to selling mobile phones successfully in the US and Europe – sets him well apart from all other Chinese tech entrepreneurs I’ve met. He is ethnically Chinese, but before coming to Shenzhen three years ago, had never lived or worked in China and his Chinese language ability, by his own admission, is so-so. Now 25, Pei was raised mainly in Sweden.
To understand Pei’s approach to business, it’s useful to understand something about business and culture in Sweden. It’s a small country, with less than 10 million people and fewer than 17,000 Chinese. Yet, it has arguably produced more innovative, world-changing companies, per capita, than any other country in the world. There’s a long list of them. My five favorites are furniture retailer IKEA, milk packaging company Tetra-Pak, bearing manufacturer SKF, fashion retailer H&M and music streaming company Spotify. In each case, these companies now dominate entire industries, with high-quality products and fair prices. Sweden has no real luxury brands. Instead it has a lot of great companies that have changed the ways a huge mass of people across the world live their lives, from the milk they drink to the beds they sleep on, the clothes they wear and now even the music they pay to listen to.
Sweden’s last attempt at success in mobile phones ended up badly. Ericsson once had a decent business selling basic phones, but the birth of smartphones was the death of Ericsson’s mobile business. OnePlus stands a better chance, in part because it’s a mix of Swedish focus on targeting a mass customer market together with Chinese speed and adaptability. I expect to see more of these “mixed blood” companies emerging in China, as China becomes more globalized and more welcoming to non-natives immigrating to start new businesses.
By basing itself in Shenzhen, OnePlus sits inside the world’s most densely-packed ecosystem of component, chip and contract manufacturing companies. It’s hard to imagine OnePlus could have been built as successfully anywhere else in the world. Foxconn, manufacturer of iPhones, is among the companies with its China base in Shenzhen. Intel has also moved in in force to win business from these small, nimble Chinese electronics companies.
Manufacturing smartphones in Shenzhen is comparatively easy. Far harder is convincing Americans to buy a mobile phone without a subsidy and a service contract from a network provider like Verizon or AT&T. Yet, OnePlus is so far succeeding. One reason: other companies that tried ended up spending millions of dollars on advertising to try to explain to Americans why they should buy a phone directly. It was mainly burned money. OnePlus spent nothing on advertising but used Twitter, Facebook, Google Plus and Youtube to build up a group of early adopters, who then went out and evangelized their friends.
OnePlus has 1.1mn “likes” on Facebook, double Xiaomi’s, along with four times as many followers on Twitter. On Youtube, the Oneplus channel has five times more subscribers than Xiaomi. Keep in mind Youtube, Twitter and Facebook are banned in China, where all of OnePlus’s employees are. OnePlus has become an expert at selling and brand-building using websites OnePlus’s own team aren’t supposed to even be looking at.
Ask Carl how he figured out how to do things in the US market that American companies, including hundreds with millions of dollars in VC money, weren’t able to do and he just shrugs, like it was all pretty easy. OnePlus still has no office in the US, no staff there, no repair centers, nothing. In the beginning you could only buy a OnePlus in the US and Europe with an invitation. Even with one, OnePlus only accepted orders from new customers one day a week, on Tuesdays. As OnePlus’s reputation grew, the invitations became themselves valuable commodities. They still sell on eBay for $10-$20 each. OnePlus is now gradually loosening up and letting those without an invitation buy its phones, but again, only one-day-a-week, on Tuesdays.
Selling by invitation only may seem counterproductive. But, it’s proved vital to OnePlus’s success up to now. The reason: making mobile phones is generally a very cash-intensive business, since you need to have huge amounts of working capital to buy parts, build phones, supply to retail channels, and then wait for cash to return. OnePlus had no access to a big pot of working capital. So they have basically built phones to order, after the customer has paid.
One-third of the OnePlus’s 400 staff, including about 50 non-Chinese, are dedicated to customer service, which mainly means answering emails and responding to comments and questions on the company’s website and forums. This is another core thing OnePlus does better than any company I’ve seen in China. It’s establishing a new idea in the US and Europe about what a Chinese company is and does. Not just a source of cheap manufactured goods, but a company with a clear and powerful brand identity, one knows how to communicate well and sell things to college-educated 20-30 year-olds who live in San Francisco, Berlin and London.
Success has come quickly, but Pei, from my discussion over dinner with him, is certainly not complacent. He sees risks everywhere, not only from the obvious examples of Nokia and Blackberry, two once world-conquering mobile phone companies that have all but disappeared from the market. Apple remains very powerful. It and Google also own a lot of the key intellectual property patents for mobile phone signal processing, software and chip design. If either chooses to sue OnePlus, they have far more money to fight a patent lawsuit in a US court. Legal fees could easily top $20mn, money OnePlus does not now have. The US patent law system has been abused before, a big company sues a small but fast-growing one, not because it has a good legal case, but knowing that fighting the lawsuit, paying the legal bills, can put this new competitor out of business.
Pei’s three burning concerns are the OnePlus fails to attract enough talented global executives to join the company, loses its edge in designing hardware and software, or grows too large to maintain its quirky brand image and identity. OnePlus is in the process of opening new offices and moving key people from Shenzhen to Bangalore and Berlin because Pei believes it will be easier to find talented staff there.
Another worry, surprisingly, is how and when to bring in venture capital investors. OnePlus will likely try to raise money from one of the world’s famous Silicon Valley VCs. They have the most experience investing in disruptive businesses, helping startups like OnePlus to grow, especially in the US market, and they also can provide lots of help finding top executives and distribution partners. But, these Silicon Valley VCs have also not seen anything exactly like OnePlus before, a Chinese startup, likely with some core operations in India, and a magical ability to sell to Americans without having any Americans involved. If successful, OnePlus could have one of the largest Series A VC rounds in history, raising perhaps $100mn-$200mn. Will money spoil the company or improve it?
OnePlus’s revenues are on track to more than triple this year to over $1 billion. But, there are lots of places where OnePlus could stumble and fall. Its new model launches and software upgrades could get delayed. Cost pressures could force them to raise prices in the US as they recently had to do in Europe, because of steep fall in the Euro. Also, US and European early-adopters are a fickle bunch. They could start throwing bricks at OnePlus instead of kisses. Case in point, in less than two years, Taiwanese mobile phone company HTC went from the most talked-about and fastest-growing company in the industry to an also-ran.
China’s mobile phone industry, as well as much of the TMT sector, have a reputation for being not much more than a bunch of knock-off artists, with no real innovation worthy of the name. OnePlus and Xiaomi both point the way towards a different and better future for China industry. Yes, OnePlus is good at assembling components cheaply. But, its core strengths as a company are too rarely found in China: an obsessive focus on product design, product quality, branding and customer engagement. These are what determine a company’s value as well as competitive strength. OnePlus is the first Chinese company to gain a large number of buyers and fans in the US and Europe by being simultaneously good at all these.
China’s long-term economic competiveness requires that more companies like OnePlus emerge. But, until it came along, China didn’t have a single one. It’s the most concrete sign that China may transition away from being a source of copy-cat products sold cheap and begin to play in the global big leagues, generating buzz while competing and taking market share from large, rich incumbents like Google and Samsung.
For these two, as well as companies wishing to find a buyer in China, the game now is to learn the new rules of China M&A and then learn to use them to one’s advantage.
Chinese companies mainly pursue M&A for the same reasons others do – to improve margins, gain efficiencies and please investors. The main difference, and it’s a striking one, is that in most cases domestic Chinese corporate buyers, especially the publicly-quoted ones who are most active now trying to do deals, have no money to buy another business.
Outside of China, there are three known ways to pay for an acquisition – with cash, borrowed money, or shares. All three are generally between excruciatingly slow and impossible for publicly-listed Chinese companies. The reason: companies’ retained earnings are just about always insufficient.
Banking and securities rules in China severely restrict the way publicly-traded companies in China can finance acquisitions using debt or by issuing new shares. Deals financed with leverage are basically forbidden. So, Chinese companies have invented two convoluted ways to get M&A done. They display a certain genius. Both involve trying to buy first and pay later.
Method One is for the acquirer to first negotiate a purchase then ask the Chinese stock market to suspend trading in its own shares. The acquirer will announce the deal publicly and if all goes to plan its share price will surge, often by as much as 50 per cent to 75 per cent.
This predictable outcome is the result of the fact almost all shares quoted in China are owned by small retail investors, commonly called Chinese brokers “old grandpas and grandmas”. Most have never cared to look at a company’s financials or studied its competitive position. Instead, they trade in and out of stocks depending mainly on rumor and hype fed to them by brokers or online tip sheets.
In China, an announced M&A deal is now always a market-moving event. The movement tends to be all in one direction. Up.
Once trading in the acquirer’s shares resumes and the price duly jumps up, the acquirer then initiates the laborious process of applying to the Chinese securities regulator, the China Securities Regulatory Commission (CSRC), for permission to do a secondary share offering.
This will then, it’s hoped, yield the cash to complete the acquisition. The approval process will generally take six months or longer. Chinese securities rules are cumbersome and mandate that the new shares be issued at a discount to the share price at the time of application.
The result: the sequence of “announce first, then apply” means the acquirer can raise the cash needed to buy the target on more favorable terms for the acquiring company, lowering the amount of dilution.
Method Two, a close cousin, is to persuade a friendly domestic investment fund to buy the target company then hold onto it for as long as it takes the intended final owner to get the money in place through the secondary offering. In other jurisdictions, this might be deemed a “concert party” and so likely to land everyone in jail. In China, it’s becoming common practice.
In fact, a new form of investment fund has come into being especially to do deals like this. They call themselves “市值管理基金” which you can translate as “market cap management funds”. They exist to help publicly-traded companies do M&A deals that will lift the company’s share price, and not much else.
They make money buying and selling shares, as well as marking up for resale companies they buy on behalf of publicly-traded companies. They are not buyout funds as understood elsewhere, since these market cap management funds are buying on behalf of a specific company and have no particular industry expertise or experience managing an acquired company. They act purely as a temporary custodian.
Most often, the acquirer will contribute a small amount of limited partner capital to the “market cap management fund” as a way to bind the two organisations together. It can take a year or more from when the market cap management fund first buys the target company then sells to the publicly-traded acquirer, and from there, several more years before this acquisition starts to have an impact, if any, on the acquiring company’s earnings. In other words, a very long timetable.
That by itself is not a problem for the acquirer, since it is as eager to give a shot of adrenalin to its own share price and maintain it on this higher plane as it is to get control of the target company and integrate it into its business. Market cap management trumps industrial logic as a reason to pursue M&A.
I’ve yet to see evidence of much skepticism from Chinese stock market investors that an announced M&A deal may not benefit the acquirer. In the US and other more developed capital markets, it’s frequently the opposite. An acquiring company will as often as not see its shares fall when it announces plans for a takeover. That’s because in most cases, as far as hard empirical evidence can determine, the main beneficiaries of any M&A deal are the target company’s shareholders. Too often, for acquirers M&A deals prove to be too expensive and synergies elusive.
We’ve been invited by domestic listed companies in China to help consult on M&A deals where “market cap management” was an explicit purpose. Finding an attractive target is also a consideration, but a somewhat secondary one.
The discussions, in the main, are unlike anywhere else where M&A deals are being planned and executed. They revolve around how to get the money together, when and for how long to halt share trading, and by how much the listed company’s shares will likely go up, and stay up, once the M&A announcement is made.
Where the publicly-listed company has private sector, rather than State-owned enterprise background, the chairman will usually be the largest single shareholder. The chairman’s net worth stands to get the biggest boost if market cap management works as planned.
Opportunities for global buyout funds
The lengthy, roundabout nature of Chinese M&A is creating attractive opportunities for global corporations and buyout firms. They are the only participants in the M&A arena in China both with cash in hand or easily accessed to close deals and the experience to manage a company well once it’s bought.
From the perspective of potential Chinese sellers, both of these are extremely valuable, since they remove much of the uncertainty in agreeing to sell to a domestic acquirer. Global corporates and buyout firms will thus often be buyers of first choice for sellers.
For now, few global corporates and buyout firms are busy closing M&A deals in China. There are a host of reasons, including China’s slowing economic growth, the perception China is becoming more hostile towards foreign investment, the difficulty persuading owners of better Chinese companies to give up majority control. All valid concerns. But, there are larger forces now at work that make it attractive to expand through acquisition in the world’s largest fast-growing market.
First, in almost all industrial and service industries, China is beginning at last a process of rationalisation and consolidation. Costs are rising quickly, especially for labor, energy and debt service. These are applying vice-like pressure on margins. Markets for most products and services in China are no longer growing by +25 per cent a year and suffer from overcapacity.
Scale, efficiency, quality, modern management are the only ways to combat the punishing margin pressure. This plays directly to the strengths of larger global corporations and buyout firms. They know how to do this, how to transform a capable smaller business into a large market-share leader.
It’s something of a well-kept secret, but some of the world’s most successful M&A deals have seen large global corporations buying private sector businesses in China. The successful buyers generally prefer it this way, that few know how well they are doing after buying and upgrading a Chinese domestic company.
Why tip off competitors? For every well-publicized horror story there are at least three quiet successes. Indeed, one can find within a single Fortune 500 company three great examples of how to do domestic M&A well in China, and achieve a big payoff. The company is Swiss food giant Nestle.
They first opened an office in China in 1908. The big transformation began a hundred years later, in 1998, when they decided to buy an 80 per cent ownership in a Chinese powdered bullion company Taitaile. That company is now more than twelve times the size it was when Nestle bought in.
They followed that up with two other large acquisitions of domestic Chinese food and beverage brands, drinks company Yinlu and candy brand Hsu Fu Chi. In all cases, Nestle bought majority control, but not 100 per cent. They kept the founder in place, as CEO and a minority owner.
That has proved a brilliant model for successful M&A in China, and not only at Nestle. When discussing with Chinese business owners the advantages of selling control to a capable global company, we often share details of Nestle’s M&A activity in China, including the fact that the Chinese owner stays but gets to spend Nestle’s money, leverage its resources, to build a giant business. That’s a pretty attractive proposition.
All three acquisitions have thrived under Nestle’s ownership and now enjoy significant market shares. Thanks largely to these acquisitions, China is Nestle’s second-largest market overall. It was number seven just four years ago.
From my discussions with the China M&A team at Nestle, they are frank that it’s not always been smooth sailing. The M&A deals all involved trying to blend one of the world’s most fastidious, slow-moving and more bureaucratic cultures with the free-wheeling, “ready, fire, aim” style common to all Chinese domestic entrepreneurs. Corporate culture gaps could not get any wider. And yet, it’s worked out well, better in fact than Nestle hoped when going in.
Nestle tells us it is hungry to do more acquisitions in China. Chinese still spend half as much on food per capita as Mexicans. That’s where the growth will come from. Market dynamics in China are also moving strongly in Nestle’s favor, as food quality and safety become paramount concerns. Further acquisitions should help Nestle gather in billions more in revenue in China along with higher market shares.
Across multiple industries, the circumstances are similar in China, and so favor smart, bold acquirers. Choose good targets, buy them at a good price, convert great entrepreneurs to great managers and partners, don’t script everything from your far-off global headquarters. Do these right and M&A can work in China. No market cap management required.
(Originally published Financial Times BeyondBrics)
Peter Fuhrman, CEO of China First Capital, explains how the country’s private equity market has struggled with profit returns and the importance of diversified exit strategies. He also predicts the rise of new funds to execute high-yield deals
Date: 05 May 2015
What is China First Capital?
China First Capital is an investment bank and advisory firm with a focus on Greater China. Our business is helping larger Chinese companies, along with a select group of Fortune 500 companies, sustain and enlarge market leadership in the country, by raising capital and advising on strategic M&A. Like our clients, we operate in an opportunity-rich environment. Though realistic about the many challenges China faces as its economy and society evolve, we are as a firm fully convinced there is no better market than China to build businesses of enduring value. China still has so much going for it, with so much more growth and positive change ahead. As someone who first came to China in 1981 as a graduate student, my optimism is perhaps understandable. The positive changes this country has undergone during those years have surpassed by orders of magnitude anything I might have imagined possible.
After a rather long career in the US and Europe, including a stint as CEO of a California venture capital company as well as a venture-backed enterprise software company, I came back to China in 2008 and established China First Capital with a headquarters in Shenzhen, a place I like to think of as the California of China. It has the same mainly immigrant population and, like the Silicon Valley, is home to many leading private sector high-tech companies.
What is happening in China’s private equity (PE) market?
Back in 2008, China’s financial markets, the domestic PE industry, were far less developed. It was, we now can see, a honeymoon period. Hundreds of new PE firms were formed, while the big global players like Blackstone, Carlyle, TPG and KKR all built big new operations in China and raised tons of new money to invest there. From a standing start a decade ago, China PE grew into a colossus, the second-largest PE market in the world. But, it also, almost as quickly, became one of the more troubled. The plans to make quick money investing in Chinese companies right ahead of their planned IPO worked brilliantly for a brief time, then fell apart, as first the US, then Hong Kong and finally China’s own domestic stock exchanges shut the doors to Chinese companies. Things have since improved. IPOs for Chinese companies are back in all three markets. But PE firms are still sitting on thousands of unexited investments. The inevitable result, PE in China has had a disappointing record in the category that ultimately matters most: returning profits to limited partners (LPs).
Like many other facets of the financial services industry, the private equity (PE) asset class has endured a turbulent and difficult period since the onset of the financial crisis. Critics of the industry were quick to colour the PE space as a den of iniquity, a place for vultures and destroyers of jobs. In recent years, the sector has been required to comply with an increasingly tight set of regulatory requirements.
Chinese PE activity, by contrast, was rather more subdued. “In 2014, the gap between the performance of the private equity industry in China and the US opened wide,” says Peter Fuhrman, chairman and founder of China First Capital, a China-focused global investment bank. “The US had a record-breaking year, with 10-year net annualised return hitting 14.6 percent. 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. While IPO exits for Chinese companies in the US, Hong Kong 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.”
This report examines some of the unique attributes of China debt investing, especially its fast-growing high-yield “non bank” shadow banking sector. Do the high yields adequately price in risk? Is this an investment class international investors should consider? Can the regulatory Great Wall be scaled to get dollars legally in and out for lending in China?
Little has been written in English about China’s huge high-yield debt market except constant predictions of its imminent catastrophic demise. Search “China shadow banking crash” and Google turns up 390,000 books and articles in English, some dating back five years now. One sample among many, a 2013 book by James Gorrie titled, “The China Crisis: How China’s Economic Collapse Will Lead to a Global Depression”. It perfectly captures the near-unanimous tenor of Western experts and analysts that shadow banking is the iceberg China has already struck. Losses will run into the billions of dollars, we are told, and China’s entire banking industry will teeter and perhaps collapse in a devastating replay of the 2008 financial crisis in the US and Europe.
Those of us in China inhabiting the world of fact rather than prediction, however, will have noticed that there is no crisis, no iceberg, no titanic upsurge of defaults in China’s shadow banking systems. In fact, it is by far the world’s largest, and using actual default statistics rather than somebody’s forecast, the least risky high-yield debt market in the world. There’s good money to be made.
Our report offers only one prediction — that as rules are loosened, global institutional capital will begin to put money into high-yield lending in China, likely by making direct loans to the best of China’s corporate and municipal borrowers. They will do so because debt investing in China offers institutional investors diversification as well as potentially higher risk-adjusted returns than private equity or venture capital.
The report examines high-yield lending in China as an investment strategy for fixed-income investors. In that, it may well be a first to do so. Are there risks in the high-yield market in China? Of course, as there is in all fixed-income investing, including, in theory, the safest and most liquid of all instruments, US Treasury bills, bonds and notes.
Are actual default rates in China high-yield lending likely to surge above the current reported level of 1%? Yes, it seems entirely possible. But, this hardly invalidates the attractions of lending there. Instead, it means lenders, be they large credit funds or institutional investors acting directly as a source of debt capital to borrowers in China, should perfect their collateral at the outset, do first-rate credit analysis before money moves and then, no less important, be extremely hands-on with on-site cash flow monitoring after a loan has been made.
There are 1,000 good reasons for institutional investors to consider China’s high-yield debt market. That’s because of the 1,000-basis point yield premium available in China compared to making similar types of loans against similar collateral to similarly rated companies outside China. In other words, an investor can earn far more with an intelligent direct lending strategy than is possible in all other major economies, as well as more than one can earn even in poorer domains like Indonesia and India.
The report looks at lending and credit markets in China from several different vantage points, including a few case studies. It’s a fascinating topic for anyone who wishes to learn more. Why are interest rates so much higher in China? Who are the winners and losers? Why is it there this near-unanimous view among English-speaking financial analysts and media folk that the high-yield market in China is on the verge of a ruinous crash? Do they share a common gift for doom-laden exaggeration like Nostradamus or will before very long be proven right at last?
I know which way I vote on that, that the shadow banking industry will certainly suffer some stumbles, with individual deals going sour and money being lost. But, as more money enters China for the purpose of providing debt capital, the shadow banking industry will mature, will improve its credit-analysis and credit-pricing skills, and smart investors will do well both relative to other fixed-income investment strategies worldwide as well as compared to private equity investing in China.–
The cost of borrowing money is a huge and growing burden for most companies and municipal governments in China. But, it is also the most attractive untapped large investment opportunity in China for foreign institutional investors. This is the broad outline of the Chinese-language essay published in this week’s Caijing Magazine, among China’s most well-read business publications. The authors are me and Dr. Yansong Wang, China First Capital’s Chief Operating Officer.
Foreign investors and asset managers have mainly been kept out of China’s lucrative lending market, one reason why interest rates are so high here. But, the foreign capital is now trying to find ways to lend directly to Chinese companies and municipalities, offering Chinese borrowers lower interest rates, longer-terms and less onerous collateral than in the Rmb15 trillion (USD $2.5 trillion) shadow banking market. Foreign debt investment should be welcomed rather than shunned, our commentary argues.
If Chinese rules are one day liberalized, a waterfall of foreign capital will likely pour into China, attracted by the fact that interest rates on securitized loans here are often 2-3 times higher than on loans to similar-size and credit-worthy companies and municipalities in US, Europe, Japan, Korea and other major economies. The likely long-term result: lower interest rates for company and municipal borrowers in China and more profitable fixed-income returns for investors worldwide.
I’ve written in English on the problem of stubbornly high borrowing costs in China, including here and here. But, this is the first time I tried to evaluate the problem for a Chinese audience — in this case, for one of the more influential readerships (political and business leaders) in the country.
The Chinese article can be downloaded by clicking here.
For those who prefer English, here’s a summary: high lending rates exist in China in large part because the country is closed to the free flow of international capital. The two pillars are a non-exchangeable currency and a case-by-case government approval system, managed by the State Administration of Foreign Exchange (SAFE) to let financial investment enter, convert to Renminbi and then leave again. This makes it all but impossible to arbitrage the 1,000 basis point interest rate differential between China domestic corporate borrowers and similar Chinese companies borrowing in Hong Kong.
Foreign financial investment in China is 180-degrees different than in other major economies. In China, almost all foreign investment is in equities, either through buying quoted shares or through giving money to any of the hundreds of private equity and venture capital firms active in China. Outside China, most of the world’s institutional investment – the capital invested by pension funds, sovereign wealth funds, insurance companies, charities, university endowments — is invested in fixed-income debt.
The total size of institutional investment assets outside China is estimated to be about $50 trillion. There is a simple reason why institutional investors prefer to invest more in debt rather than equity. Debt offers a fixed annual return and equities do not. Institutional investors, especially the two largest types, insurance companies and pension funds, need to match their future liabilities by owning assets with a known future income stream. Debt is also higher up the capital structure, providing more risk protection.
Direct loans — where an asset manager lends money directly to a company rather than buying bonds on the secondary market — is a large business outside China, but still a small business here. Direct lending is among the fastest-growing areas for institutional and PE investors now worldwide. Get it right, and there’s no better place in the world to do direct corporate lending than in China.
For now, direct lending to Chinese companies is being done mainly by a few large US hedge funds. They operate in a gray area legally in China, and have so far mainly kept the deals secret. The hedge fund lending deals I’ve seen have mainly been short-term lending to Chinese property developers, at monthly interest rates of 2%-3%.
I see no benefit to China from such deals, nor would I risk a dollar of my own money. A good rule in all debt investing is whenever interest rates go above 20% a year, the lender is effectively taking on “equity risk”. In other words, there are no borrowers anywhere that can easily afford to pay such high interest rates. Anyone who will take money at that price is probably unfit to hold it. At 20% and above, the investor is basically gambling that the desperate borrower will not run out of cash while the loan is still outstanding.
Interest rates are only one component of the total cost of borrowing for companies and municipalities in China’s shadow banking system. Fees paid to lawyers, accountants, credit-rating agencies, brokerage firms can easily add another 2% to the cost of borrowing. But, the biggest hidden cost, as well as inefficiency of China’s shadow banking loan market is that most loans from this channel are one-year term, without an automatic rollover.
Though they pay interest for 12 months, borrowers only have use of the money for eight or nine months. The rest of the time, they need to accumulate capital to pay back principal at the end of one year. China is the only major economy in the world where such a small percentage of company borrowing is of over one-year maturity. China’s economy is guided by a Five Year Plan, but it’s domestic lenders operate on the shortest of all time-frames.
If more global institutional capital were allowed into China for lending, I would expect these investors to want to do their own deals here in China, negotiate directly with the borrower, rather than buying existing securitized shadow banking debt. These investors would want to do more of their own due diligence, and also tailor each deal, in a way that China’s domestic shadow banking system cannot, so that the maturity, terms, covenants, collateral are all set in ways that correspond to each borrowers’ cash flow and assets.
China does not need one more dollar of “hot money” in its economy. It does need more stable long-term investment capital as direct lending to companies, priced more closely to levels outside China. Foreign institutional capital and large global investment funds could perform a useful role. They are knocking on the door.
For all the media ink spilled, including by Reuters’ excellent Asia fixed income correspondent Umesh Desai, you’d think the ongoing fight in Hong Kong between severely-troubled Chinese real estate developer Kaisa Group and its creditors was the biggest, nastiest, most portentous blood feud the capital markets have ever seen. It’s none of that. It’s a reasonably small deal ($2.5 billion in total Hong Kong bond debt that may prove worthless) involving a Chinese company of no great significance and a group of unnamed bond-holders who are screaming bloody murder about being asked to take a 50% haircut on the face value of the bonds. The creditors have brought in high-priced legal talent to argue their case, both in court and in the media. Me thinks they doth protest too much.
Nothing wrong with creditors fighting to get back all the money they loaned and interest they were promised. But, what goes unspoken in this whole dispute is the core question of what in heaven’s name were bond investors thinking when they bought these bonds to begin with. Kaisa was, if not a train wreck waiting to happen, then clearly the kind of borrower that should be made to pay interest rates sufficiently high to compensate investors for the manifold risks. Instead, just the opposite went down. The six different Kaisa bond issues were sold without problem by Hong Kong-based global securities houses including Citigroup, Credit Suisse and UBS to some of the world’s most sophisticated investors including Fidelity and Blackrock by offering average interest rates of around 8%. If Kaisa were trying to raise loans on its home territory in China, rather than Hong Kong, there is likely no way anyone would have loaned such sums to them, with the conditions attached, for anything less than 16%-20% a year, probably even higher. Kaisa’s Hong Kong bonds were entirely mispriced at their offering.
It may strain mercy, therefore, to feel much sympathy for investors who lose money on this deal. Start with the fact Kaisa, based where I am in Shenzhen, is a PRC company that sought a stock market listing and issued debt in Hong Kong, rather than at home. Not always, but often, this is itself a big red flag. Hong Kong’s stock exchange had laxer listing rules than those on the mainland. As a result, a significant number of PRC companies that would never get approval to IPO in China because of dodgy finances and laughable corporate governance managed to go public in Hong Kong. Kaisa looks like one of these. It has a corporate structure, which since 2009 has been basically illegal, that used to allow PRC companies to slip an offshore holding company at the top of its capital structure.
The bigger issue, though, was that bond buyers clearly didn’t understand, or price in, the now-obvious-to-all fact that offshore creditors (meaning anyone holding the Hong Kong issued debt of a PRC domestic company) would get treated less generously in a default situation than creditors in the PRC itself. The collateral is basically all in China. Hong Kong debt holders are effectively junior to Chinese secured creditors. True to form, in the Kaisa case, the domestic creditors, including Chinese banks, are likely to get a better deal in Kaisa’s restructuring than the folks in Hong Kong.
This fact alone should have mandated Kaisa would need to promise much sweeter returns and more protections to Hong Kong investors in order to get the $2.5 billion. Investors piled in all the same, and are now enraged to discover that the IOUs and collateral aren’t worth nearly as much as they expected. Kaisa bonds were, in effect, junk sold successfully as something close to investment grade. As long as the company didn’t pull a fast one with its disclosure – an issue still in dispute – it’s fair to conclude that bond-buyers really have no one to blame but themselves.
At this point, it’s probable many of the original owners of the Kaisa bonds, including Fidelity and Blackrock, have sold their Kaisa bonds at a loss. Kaisa’s bonds are trading now at about half their face value, suggesting that for all the creditors’ grousing, they will end up swallowing the restructuring terms put forward by Kaisa. If the creditors don’t agree, well then the whole thing will head to court in Hong Kong. If that happens, Kaisa has threatened to default, which would probably leave these Hong Kong bondholders with little or nothing. Indeed, Deloitte Touche Tohmatsu has calculated that offshore creditors in a liquidation would receive just 2.4% of what they are owed. The collateral Kaisa pledged in Hong Kong may be worth more than the paper it was printed on, but not much.
The real story here is the systematic mispricing of PRC company debt issued in Hong Kong. It’s still possible, believe it or not, for other Chinese property developers with similar structure and offering similar protections as Kaisa to sell bonds bearing interest rates of under 9%. Meantime, as discussed here, Chinese property companies in some trouble but not lucky enough to have a holding company outside China are now forced to borrow from Chinese investors, both individuals and institutions, at 2%-3% a month.
It’s a situation rarely seen – investors in a foreign domain provide money much more cheaply against shakier collateral than the locals will. Kaisa’s current woes are part-and-parcel of at least some of the real estate development industry in China. It seems to have engaged in corrupt practices to acquire land at concessionary prices. Kaisa got punished by the Shenzhen government. It was forbidden to sell newly-built apartment units in Shenzhen. No sales means no cash flow which means no money to pay debt-holders. Kaisa is far from the first Chinese real estate developer to run into problems like this. And yet, again, none of this, the “politico-existential” risk many real estate development companies face in China, seems to have made much of an imprint on the minds of international investors who lined up to buy the 8% bonds originally. After all, the interest rate on offer from Kaisa was a few points higher than for bonds issued by Hong Kong’s own property developers.
Global institutional investors like Blackrock and Fidelity might control more capital and have far more experience pricing debt than Chinese ones. But, in this case at least, they showed they are far more willing to be taken for a ride than those on the mainland.
What’s ailing China? Explanations aren’t hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.
Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China’s economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies, especially in the private sector where most of the best Chinese companies can be found, are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.
Logic would suggest that the high rates price in some of the world’s highest loan default rates. This is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany, all countries incidentally where companies can borrow money for 2-4% a year.
You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting that the banking system in China is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money overseas, including Hong Kong-listed property developer Kaisa Group, have come near default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.
Combine sky-high real interest rates with near-zero defaults and what you get in China is now probably the single most profitable place on a risk-adjusted basis to lend money in the world. Also one of the most exclusive: the lending and the sometimes obscene profits earned from it all pretty much stay on the mainland. Foreign investors are effectively shut out.
The big-time pools of investment capital — American university endowments, insurance companies, and pension and sovereign wealth funds — must salivate at the interest rates being paid in China by credit-worthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. They are kept out of China’s lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.
This is starting to change. But it takes clever structuring to get around a thicket of regulations originally put in place to protect the interests of China’s state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms while giving lenders outside China access to the high yields best found there.
China’s high-yield debt market is enormous. The country’s big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.
Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the so-called shadow-banking sector, are now in excess of 100 trillion yuan ($15.9 trillion) or about double total outstanding commercial loans in the U.S. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability and distorting investment and rational long-term planning.
A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding recently has done. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don’t all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.
Chinese loans are not only expensive, they are just about all short-term in duration — one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won’t lend for longer.
The loans get called every year, meaning borrowers really only have the use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world’s most overpriced and rigid credit systems.
It is now taking longer and longer to renew the one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal money-lenders to tide them over after repaying last year’s loan while waiting for this year’s to be dispersed. The cost for this so-called “bridge lending” in China? Anywhere from 3% a month and up.
Again, we’re talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business, private-sector companies with revenues well in excess of 1 billion yuan, with solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can’t build long-term prosperity where long-term lending is unavailable.
Same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won’t go near services companies, unless of course, they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.
Chinese companies used to find it easier to absorb the cost of their high-yield debt. No longer. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.
Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, earned one-third of all profits of the entire global banking industry, amounting to $292 billion in 2013. The government is trying to force a little more competition into the market, and has licensed several new private banks. Tencent Holdings and Alibaba, China’s two Internet giants, both own pieces of new private banks.
Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China’s economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China’s economy is moving more in the direction of the market should look to a single touchstone: is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?
Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.
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 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?
January 23, 2015 1:00 pm JST
By Peter Fuhrman
China’s economy suffers from an acute case of “not invented here” syndrome. Everything can be, and increasingly is, manufactured in China, but almost nothing of value is invented here.
The result is an economy still centered on low-pay, low-margin drudge work manufacturing products designed, patented and marketed by others. This is as true for advanced medical diagnostic equipment from General Electric as it is for Apple’s iPhones and tablets.
While manufacturing accounts for almost 50% of China’s gross domestic product and keeps 100 million people employed, China has few if any domestic companies selling sophisticated, premium-priced manufactured products to the world. As long as this remains the case and China remains a huge economy with only the tiniest sliver of consequential and profitable innovation, it will grow harder each year for the country to sustain high economic growth rates and big increases in living standards.
The government is increasingly anxious. “China is now standing at a critical stage in that its economic growth must be driven by innovation,” warned the State Council, China’s cabinet, in May.
With the talk comes money. Lots of it. Billions of dollars are being allocated to government-backed research projects and venture capital. But for all the rhetoric, government policies and cash, China remains a high-tech disappointment, more dud than ascending rocket. As an investment banker living and running a business in China, I very much wish it were otherwise. But I still see no concrete evidence of a major change underway.
On others’ shoulders
Indeed, the flagship products of China’s advanced manufacturing sector are still built largely on foreign components, technologies and systems, with Chinese factories serving as the assembly point.
Consider Xiaomi, which achieved great success in China’s mobile phone market last year and began getting some traction overseas. The company now has a market valuation of $45 billion, far higher than Sony, Toshiba, Philips, Ericsson and many more of the world’s most famous innovators.
Xiaomi’s handsets rely on components and software from a group of mainly U.S. companies, including Broadcom, Qualcomm and Google. They, along with U.K. chipmaker ARM Holdings and foreign screen manufacturers, are the ones making the real money on Android phones like Xiaomi’s.
Many of Xiaomi’s phones, like those of Apple and other leading brands, are assembled in China by Hon Hai Precision Industry, a Taiwanese company better known as Foxconn. As of now, Foxconn has no Chinese competitor that can match its production quality at a comparable low cost. Its superior management systems for high-volume production underscore another critical area where China’s domestic technology industry is weak.
The picture is similar with products such as computers, cars and aircraft. China’s military and commercial jet development programs have relied on foreign engines because of the country’s continuing failure to design and produce its own. Compare this with the Soviet Union, which, though an economic also-ran all the way up to its extinction in 1991, was producing jet engines as early as the 1950s; Russia still supplies advanced military engines for Chinese military jets. The picture is little better with jet brakes and advanced radar systems.
Stumbling blocks in China’s jet engine development continue at the manufacturing level with difficulties in serial production of minute-tolerance machinery, at the materials level with a lack of special alloys, and at the industrial level where a state-owned monopoly producer faces no local competitor to drive innovation as has been seen in the dynamic in the U.S. between GE and Pratt & Whitney.
China’s inability to make its own advanced jet engines casts light on problems China has, and likely will continue to have, developing a globally competitive indigenous technology base. This challenge, to bring all the parts together in a high-tech manufacturing project, is also evident in China’s failure, up to now, to develop and sell domestically developed advanced integrated circuits, pharmaceuticals and new materials globally.
China has, by some estimates, spent more than $10 billion on pharmaceutical research, but it has had only one domestically developed drug accepted in the global market, the modestly successful anti-malarial treatment artemisinin, or qinghaosu. Interestingly, it is derived from an herbal medicine used for 2,000 years in China to treat malaria; the drug was first synthesized by Chinese researchers in 1972.
It’s simply not enough to count Chinese engineers and patents, or to rely on the content of the government’s technology-promoting policies. China still lacks so many of the basic building blocks of high-tech development, such as a mature, experienced venture capital industry staffed by professional entrepreneurs and technologists. A transparent judicial system is also essential, not only for protecting patents and other intellectual property, but for managing the contractual process that allows companies to put money at risk over long periods to achieve a return. Nondisclosure and noncompete agreements, a backbone of the technology industry in the U.S. and elsewhere, are basically unenforceable in China.
Tencent Holdings’ WeChat mobile messaging service is an example frequently cited by those who claim to see a dawning of innovation in China. An impressive 400 million phone users have signed up for the service. The basic application, though, is similar to that of Facebook’s WhatsApp, Japan’s Line and others.
WeChat’s real technological strength is in its back end, in building and managing the servers to store all the content that is sent across the network, including a huge amount of video and audio files. Tencent does this because it’s required to do so by Chinese internet rules and government policies on monitoring Internet content. Tencent might be able to commercialize and sell its backend storage architecture globally, but it’s not clear anyone would be interested in buying it. It’s a technology that evolved from specific Chinese requirements, not market demand.
China’s record of invention is the stuff of history: gunpowder, the compass, paper, oil wells, porcelain, even alcoholic beverages, kites and the fishing reel. All that occurred over 1,000 years ago. China’s greatest modern invention has been its singular pathway out of poverty as the economy expanded 200-fold over the last 35 years. But growth is now slowing, costs are rising sharply and profit margins are shrinking. To go on prospering, China needs to invent a new path and discover a new wellspring of breakthrough innovation, and it needs to do so in a hurry.
The secret is out. Chinese now know, in far greater numbers than before, that the favorite brand of the favorite staple food of hundreds of millions of them is made by a huge American company, General Mills, best known for sugar-coated cereals served to American children. (See my earlier article here.) In the current issue of China’s weekly business magazine Caijing is my Chinese-language article blowing the cover off the well-hidden fact that China’s tastiest and most popular brand of frozen dumplings, known in Chinese as 湾仔码头, “Wanzai Matou”, is made by the same guys who make Cheerios, Cocoa Puffs and Lucky Charms in the US.
You can read a copy of my Caijing article by clicking here.
Getting these facts in print was not simple. I’ve been an online columnist for Caijing for years. When I sent the manuscript the magazine’s editor, he did the journalistic version of a double take, refusing to believe at first that this dumpling brand he knows well is actually owned and run by a non-Chinese company, and a huge American conglomerate to boot. He asked many questions and apparently did his own digging around to confirm the truth of what I was claiming.
He asked me to reveal to him and Caijing’s readers the secret techniques General Mills has used to conquer the Chinese market. That further complicated things. It wasn’t, I explained, by selling stuff cheap, since Wanzai Matou sells in supermarkets for about double the price of pure domestic brands. Nor was it because they used the same kind of saturation television advertising P&G has pioneered in China to promote sales of its market-leading products Head & Shoulders and Tide. General Mills spends little on media advertising in China, relying instead on word of mouth and an efficient supply chain.
My explanation, such as it is, was that the Americans were either brave or crazy enough, beginning fifteen years ago, to believe Chinese would (a) start buying frozen food in supermarkets, and (b) when they did, they’d be willing to pay more for it than fresh-made stuff. Wanzai Matou costs more per dumpling than buying the hand-made ones available at the small dumpling restaurants that are so numerous in China just about everyone living in a city or reasonably-sized town is within a ten-minute walk of several.
In my case, I’ve got at least twenty places within that radius. I flat-out love Chinese dumplings. With only a small degree of exaggeration I tell people here that the chance to eat dumplings every day, three times a day, was a prime reason behind my move to China. For my money, and more important for that of many tens of millions of Chinese, the Wanzai Matou ones just taste better.
The article, though, does explain the complexities of building and managing a frozen “cold chain” in China. General Mills had more reason to master this than any company, domestic or foreign. That’s because along with Wanzai Matou they have a second frozen blockbuster in China: Häagen-Dazs ice cream, sold both in supermarkets and stand-alone Häagen-Dazs ice cream shops. Either way, it’s out of my price range, at something like $5 for a few thimblefuls, but lots of Chinese seem to love it. Both Wanzai Matou and Häagen-Dazs China are big enough and fast-growing enough to begin to have an impact on General Mills’ overall performance, $18 billion in revenues and $1.8bn in profits in 2014.
For whatever reason, General Mills doesn’t like to draw attention to its two stellar businesses in China. The annual report barely mentions China. This is in contrast to their Minnesota neighbor 3M which will tell anyone who’s listening including on Wall Street that it’s future is all about further expanding in China. But, the fundamentals of General Mills’ business in China look as strong, or stronger, than any other large American company operating here.
The title of my Caijing article is “外来的厨子会做饺子” which translates as “Foreign cooks can make dumplings”. It expresses the surprise I’ve encountered at every turn here whenever I mention to people here that China’s most popular dumpling company is from my homeland not theirs.
Watching the NFL playoffs this weekend on Chinese internet TV channel PP Live, I saw something I never imagined. No, not a live broadcast in China of American football. The NFL has a great thing going here in China. While not a big-time success yet like the NBA in China, the NFL is quietly making fans out of a meaningful slice of the country’s most gold-plated demographic: males with advanced degrees and senior management positions.
No, what surprised me while watching the game was the frequent commercials paid for in part by money from the US Department of Treasury. Yes, Uncle Sam is now involved in buying advertising time during NFL games on Chinese tv. Never quite thought I’d live to see the day.
The ads are to promote tourism to the US. There are snapshots of American scenery, a catchy little song playing in the background, and then this splash screen comes up at the end:
Follow that www.gousa.cn link and one eventually learns the group behind the ads is something called “Brand USA”, a body describing itself as a “public private partnership”. That’s generally code for some kind of organization where the US Treasury picks up some or all of the tab, but whose purpose is to help private companies make money. Sure enough. Last month, President Obama signed legislation that keeps the government money flowing to Brand USA at least through 2020, long after he’s out of office. The budget for fiscal year 2014 was $125 million.
The board of Brand USA includes top executives from hotel group Marriott International, Disney’s travel arm, the air reservation system Sabre Corporation as well as the top bureacrats in the tourist promotion office in the states of California and Minnesota. Brand USA’s chairman is president of a company I never heard of called Jackmont Hospitality, whose website says it is “a minority-owned, comprehensive foodservice management company and one of the fastest growing TGI FRIDAYS® franchisees.”
The intent of the commercial is, of course, to get more Chinese to travel to the US as tourists. A laudable goal, and one that became much easier at the end of last year when Obama and Chinese President Xi Jinping agreed a new bilateral visa regime which gives citizens of each country ten-year multi-entry visas. Chinese tourism in the US is growing, with 1.8 million visiting last year, fifth most among all countries sending tourists to the US, but still about half the number of British tourists each year.
What they lack in numbers Chinese tourists make up for in extravagance. They spend $7,200 per visit compared to $4,500 by the average foreign tourist, according to the US Travel Association.
Like a lot my government does, the commercials running during football timeouts don’t display a particularly keen knowledge of consumer marketing. The jingle is sung in English, so not likely to be understood by a lot of Chinese viewers. The places featured don’t seem likely destinations for Chinese tourists. No Times Square or Fifth Avenue Apple Store in Manhattan. No Disneyland, no Harvard Yard and no Las Vegas.
So where is the US government pushing Chinese to visit? Price Lake. I never heard of it either, but according to Wikipedia it’s in the Blue Ridge Mountains of North Carolina, about 200 miles from the nearest major airport, Raleigh-Durham. It’s said to host the largest annual gathering of lumberjacks each year. If China has a large contingent of passport-holding lumberjacks it’s news to me.
While Brand USA hasn’t been around long, it’s already attracted a fair bit of criticism, led by Republican members of Congress, who launched a formal investigation into what is called a “history of questionable expenditures and lavish spending” at the organization. The report they issued says all Board members, though officially appointed by the US Secretary of Commerce, were in fact chosen by an Obama aide from among those who “have donated to Democrats and Democratic organizations almost exclusively.”
The private sector is supposed to donate funds which the US government matches by dipping into a pool of money raised through a $10 fee charged to all tourists arriving in the US under what’s called the Visa Waiver Program. Brand USA board members have claimed the amount they spend on travel should be considered by Uncle Sam as a “donation”, including first class air fares and hotel rooms paid for by their companies. Among the claims was one for $94.87 for a two mile taxi ride in Washington DC that the report points out should cost no more than about $15 including tip. The report’s conclusion is that the Brand USA documents and expense accounts “paint a picture of mismanagement, waste, and cronyism.”
No word on what Brand USA are paying for the ads during the NFL games on PP Live. Let’s hope they drive a tough bargain. Other than the Brand USA spot, repeated over and over, I saw no other ads during the second half of the game. During many of the commercial breaks, the Chinese broadcast stays with a live feed from the stadium of the players waiting around for the timeouts to end, something one rarely gets to see while watching football in the US.
The NFL games are broadcast in China with Chinese commentary only, once an annoyance but now a source of almost infinite delight for me. In case you’re wondering, the name for football in Chinese translates as “olive ball”.
Chinese who like the sport and are persuaded by the ads to visit the US would do well to read up first on Brand USA and its public/private affairs. It’s an excellent primer on how politics and spending sometimes operate in my nation’s capitol — and so why the US has this chronic reliance on China to finance our deficits by buying US Treasuries.