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Coming Soon — A Stock Market for High-Tech Companies in Shenzhen

December 25th, 2008 No comments

Zhou Dynasty Horse Fittings

Despite delays and continuing uncertainty, 2009 should see the opening of China’s first stock market for smaller, high-growth technology companies. Modeled on the NASDAQ in the US and AIM in London, this new market will be headquartered in Shenzhen, as part of the Shenzhen Stock Exchange, the smaller of the two stock markets in China.

Overall, this is a positive development for China’s financial industry, and the private equity and venture capital communities. Since China’s Prime Minister, Wen Jiabao announced in March 2008 the planned establishment of this new stock market, after almost a decade of internal discussion, the date for the launch has steadily slid back, a casualty of the 60% fall in China’s main stock markets this year.  

The final details have not been announced, but what seems clear at this point is that this new market will have significantly lower qualifying thresholds for companies seeking a stock market listing, compared to the main boards in Shenzhen and Shanghai. The numbers talked about are net assets above RMB 20 million (US$2.8mn) and revenues above RMB 10mn (US$1.5mn). There seems to be no requirement, as of now, for companies to be profitable at the time of listing. It’s possible, therefore, that companies listed on the new exchange will have market caps that barely exceed $10mn. 

 

Here’s my thinking. The largest quoted companies on the Shanghai market are trading at a price-earnings multiple of under 12. This is down, like the broader market, by almost 60% from recent highs. Put those kind of multiples on a small company with revenues under US$2mn and profits below $1mn, and you have the possibility of market caps in that very low range. True, high-tech companies tend to enjoy higher p/e multiples than more traditional large-caps. But, even so, this new stock market will be operating in some unchartered territory for China’s financial markets — companies with comparatively thin floats, low total market value, and so, most likely, higher price volatility. 

 

This could help explain why the Chinese government has repeatedly delayed plans to launch this stock market for high-growth companies. The regulators have probably seen this year all the volatility they care to see for a long time. 

 

Of course, the key factor won’t be earnings multiples or volatility, but the quality of the underlying high-tech businesses to be quoted on this exchange. Here’s where I see bigger problems. China, like its richer neighbors in Asia, as well as Western Europe, would very much like to rival the USA in nurturing successful high-tech companies in industries like software and chip technology. Across China, there are high-tech business parks where early-stage technology companies are concentrated. By one count, there are over 5,000 across the country. But, so far, there haven’t been many big break-out successes. 

 

The simple truth is that, as other countries have learned over the last decade, it’s hard to duplicate the particular success the US has in developing successful high-tech businesses. Having a stock market for high-tech companies is certainly not much of a factor. If so, Germany, which started its own high-tech company stock market, the NeuerMarkt ten years ago, would today be awash with leading technology firms. Instead, there are few, if any good tech companies in Germany and the Neuer Markt eventually was shut down. Britain’s AIM market has also failed to produce many successes in that country. 

 

In my mind, China does have a better shot than Germany, or Britain, or Japan. The main reason: Chinese are more entrepreneurial, and there’s more a culture of prudent risk-taking than elsewhere. If any country has a shot to achieve some of the same success the US has enjoyed building great technology companies, it’s got to be China. 

 

So, I hope this new stock market gets started early in 2009. It will provide more motivation – not that much is needed – to China’s budding technology leaders, and also provide another viable exit route for venture capital investors in China

 

 

 

 

 

 

Wikipedia Adds Entry on China Private Equity

December 25th, 2008 No comments

 

Ching Dynasty wine warmer porcelain

 

At long last, Wikipedia’s online encyclopedia has added an entry on China’s private equity market. The entry is found here:  

http://en.wikipedia.org/wiki/Private_equity_in_China

 


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

December 16th, 2008 No comments

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. 

The future of PE in China — Big PE vs. Small PE

December 8th, 2008 No comments

I never much liked the term “Private Equity” since it serves two very different meanings and even more different business models. That difference has never been more stark than it is today. There is what I like to call “Big PE” and “Small PE”. One is hurting, and the other is still thriving. Luckily for China First Capital, we focus working with the part of the PE industry that’s still in good shape.  

In Big PE, large-scale, multi-billion-dollar deals are done by famous firms of the likes of Kohlberg Kravis Roberts, Blackstone and Carlyle. In Small PE , another group of PE firms thrive by finding great companies, at an earlier stage in their development, and backing them with growth capital. 

Big PE targets larger, often publicly-traded companies, or divisions of these larger firms. Using a slug of equity to support a large pile of bank debt, these private equity deals are based on acquiring a controlling interest in a company, and can deliver outstanding results by tossing out tired and underperforming management teams, tightening up on operating efficiencies, investing for growth. In 1-3 years, if things go well, the Big PE firm exits the now-improved business through either a trade sale or primary stock market listing. 

What matters most here essentially is finding a poorly-run business, with a bad capital structure and often worse management. (To take one recent example among many, think of Cerberus’s purchase of Chrysler’s from Daimler.) Ideally, a Big PE firm can turn things around quickly after buying control, and get an exit where the debt is paid off, and the underlying equity gets a very high rates of return. 

There are two big problems now in Big PE: the drying up of credit, and the shrinking valuations put on the businesses spiffed up for sale by the PE firms.  The recession compounds the problems, since the deals are built on leverage, and the bank debt will often have aggressive covenants attached to it. Those covenants (generally targeting  operating metrics like increasing EBITDA) are much harder to achieve in a down economy. Covenants get breached, deals need to be restructured with the Big PE firm pouring in more of its own capital, and the time and value of an exit go in the wrong directions: it takes longer to make less. 

Not a good business to be in at the moment. 

Then there’s Small PE, which has never looked sounder. The core skill-set here never goes out of fashion. It’s the ability to find a great company with the potential to grow far larger. Small PE firms invest their own money, for a minority stake in a business. They then provide what help they can to management, and if they’ve chosen their portfolio investments well, will wait confidently for the optimal moment to achieve a very solid return on each individual investment.  

In other words, Small PE is not built on complex financial engineering, but on good, old-fashioned “stock-picking”. 

Last month, David Rubenstein, the co-founder and managing director of Carlyle Group, one of the biggest of the Big PE,  gave a presentation in Tokyo titled “What Happened? What Will Happen? A Look At The Changing Investment And Private Equity Worlds” . Rubenstein, who has made over a billion dollars personally in the PE industry, tried to summarize all the tectonic forces destabilizing Big PE. There’s a lot of alarming stuff in his presentation. The key line: “The Credit Crisis Has Dislocated the Private Equity Industry “. (If anyone would like a copy of the Rubenstein presentation, email me at [email protected])                                                                                                                                          

Rubenstein’s prediction, which I share: Deals: Smaller, Less Frequent, More Overseas”. In particular, Rubenstein foresees more PE firms raising money to invest in Asia. The fact he cites: Asia private equity fundraising has increased but remains small at 9.2% of the $331 billion raised by U.S. PE funds in 2007 considering that the combined GDP of the above countries is 93% of the GDP of the U.S. 

No question, Big PE will now try to act more like Small PE. The problem they’ll face is that they’re not well structured to find, assess and invest in smaller-sized deals. My guess is that the good PE firms already operating in Asia – the ones we work with regularly at China First Capital – will  be able move quicker and smarter than their new Big PE rivals. Here I means firms like China Renaissance Capital, (www.crcicapital.com) which has a great record of finding strong middle-market companies in China, investing wisely and at fair valuations, and then working alongside management to create the operating conditions for an ideal exit. 

Rubenstein’s talk included a table showing the 2008 year-to-date performance of a number of the most well-known Big PE.  All the following have lost money this year. What you see here is a cumulative loss of many tens of billions of dollars:

􀂃 Tosca Fund – 62%

􀂃 Templeton Emerging – 50%

􀂃 Kensington/Citadel  –37%

􀂃 Satellite Overseas  -30%

􀂃 Marathon Global Equity – 20%

􀂃 Canyon Value Realiz. –20%

􀂃 Goldman Sachs Investment Partners –16%

􀂃 Deephaven Global –15%

􀂃 Millenium Global HY –14%

􀂃 Cantillon Europe –13%

􀂃 Zweig-Dimenna Intl. –8%

􀂃 Harbinger Offshore -5%

􀂃 Cerberus Intl. –3%

􀂃 Viking Global Equities –2%

The good Small PE firms are having far better years. My own prediction is that this performance gap will only widen over the next two years, as the deal pipelines for Asian PE firms we work with remain very strong. Big PE has to re-learn their approach, and try to master a new set of skills. All the while, they’ll be losing out on many of the best opportunities in Asia to their smaller, more nimble and more experienced rivals. 

It’s hard to find a dancing elephant. The reason: it’s hard to teach the elephant the steps.