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Private Equity and Strategic M&A Transactions in China 2009: A New Dawn

February 28th, 2009 No comments

China First Capital, a boutique investment bank, releases comprehensive analysis of five key trends for 2009 in Private Equity, Venture Capital and M&A markets in China.jpg

My firm, China First Capital, just completed our annual report on Private Equity, Venture Capital and Strategic Mergers and Acquisitions in China. I had the biggest hand in writing it, so the opinions expressed are my own. My view, overall, is one of realistic optimism. China will continue to be the world’s most robust emerging market for private equity and venture capital finance, even in a very difficult global economic environment. A big reason for this is the continuing strong performance of many private SME companies in China, especially those focused on the domestic market, rather than exports. 

China First Capital has a special affinity for these strong private SMEs. They are the only companies we choose to work with. There a few reasons for this. A big one is my personal conviction that the most important predictor of a success in private equity investing is putting money into a company with a truly outstanding boss. Ideally, the boss will also be the entrepreneur who founded the company. 

You can do all the spreadsheet modeling and projections you want, but nothing else matters quite as much as the quality and drive of the leadership at the top. In many of the good Chinese SMEs, the boss is a first-class business strategist and opportunity-seeker. Give him a dollar and he’ll bring you back five. In many of China’s larger state-owned, or partially state-owned companies in China, the boss is often more a political animal, appointed to the job as much for skills as a bureaucratic infighter as for talents at managing a business. Give him a dollar and he’ll come back in a while and ask you to lend him another three. 

SMEs, no surprise, usually run circles around their state-owned competitors in China. That’s a big reason we choose to work exclusively for SMEs. Another reason: we prefer long-term partnerships with our clients rather than one-off deal-making of larger investment banks. We act as a financial and strategic advisor to Chinese SMEs in a long-term process that 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. 

Thanks to these Chinese SMEs,  China should be among the most attractive – and active – private equity investment markets in the world in 2009. Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Indeed, private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1 billion in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market.

Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.

The report, titled “Private Equity and Strategic M&A Transactions in China 2009”, identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are:

  1. the drive for industrial consolidation;
  2. profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA;
  3. increased importance of Convertible Debt and other hybrid financings;
  4. opportunities for strategic mergers and acquisitions;
  5. well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market.

Here’s the report’s first section. I’ll add more of it in later posts.

 

 Overview  chinese-balance

       

Turbulence creates opportunity

2008 was a year of extremes in China. Extremes of joy and pride, during the Beijing Olympics. Extremes of sadness and shock following the Sichuan earthquake. Even the climate reached extremes, during China’s crippling winter storms early in 2008. 

Financially, 2008 was also a year of extremes. The stock markets in Hong Kong, Shanghai and Shenzhen rose strongly in the first months of the year, and IPOs were plentiful. By mid-year, the markets began plunging, and IPOs dried up. By year-end, Shenzhen, Shanghai and Hong Kong were all down 60% for the year. 

China’s private equity and venture capital investments followed a similar turbulent course, beginning strongly, with over $10 billion invested in Chinese companies in the first half of the years, and then the pace of new investments slowed to a crawl.   

Governments in China, the USA and around the world intervened in an unprecedented fashion to stabilize the economy and the credit markets. As we enter 2009, there is no longer any doubt that the world economy is in recession. 

The question now is when will the recovery begin and when will be a good time to begin investing again? I want to offer a personal perspective to our valued relationships, both clients and the private equity firms we work with. As Chairman of China First Capital,  Ltd, with over 20 years of experience in the capital markets, private equity and business analytics, I’ve survived my share of business cycles. One example, I was CEO of a California venture capital company during the Dot-Bust years, the last time private equity investing came to a similar standstill. Within two years, deal activity and valuations resumed their upward momentum. 

My view: the overall investment environment in China remains challenging and the effects of 2008’s turbulence are still being felt. But, 2009 will be a year of unique opportunity for private equity, venture capital and mergers and acquisitions in China. Tough times can be the best time to make money. 

Consolidation and “flight to quality”

 

 

The Chinese economy is under significant strain as 2009 begins, with growth decelerating, factories closing by the thousands and unemployment rising. Many areas of China’s domestic economy are “over-saturated”, with too many companies competing with small market shares. China is ripe for consolidation. 

In the freely competitive markets, the weakest companies will perish. The stronger competitors will be able to add market share and enjoy the virtuous cycle of increasing volumes lowering unit costs, thus boosting profits that can be re-invested to lower still further costs of production.

Chinese consumers will respond as well, and reward with more of their money the better managed companies with the most efficient manufacturing and distribution. Out of this, stronger dominant brands will emerge, and this too will push for greater consolidation.

This process is just beginning in China. China’s domestic market is huge, second only to the US. In many vertical markets (including financial services, consumer goods, distribution and logistics, retailing, fashion), each point of additional market share in China can equate to tens of millions of dollars in additional revenue.

Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate Strong regional companies will acquire competitors elsewhere in China to become national powerhouses.   

For investors, the opportunities will be unparalleled to back the Chinese companies that will thrive during this process of consolidation.  The winners will be able to increase revenues and profits strongly and sustainably, even in a weak economy.

 

 

 

 

 

 

 

 

 

 

 

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

February 21st, 2009 No comments

 

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. 

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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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China M&A: 2008 Is A Record Year, And The Strong Growth Will Continue

February 15th, 2009 No comments

snuff-bottle-21

 

Even as IPO activity all but came to a standstill in 2008, China’s M&A market reached an all-time high in 2008, with almost USD$160 billion in deals completed, according to Thomson Reuters. This makes China the biggest M&A market in Asia, for the first time ever. 

This is an important development, and I expect China’s role as Asia’s largest M&A market will continue into the future, despite the current economic slowdown. The reasons: M&A deals in China will continue to make business and financial sense. China’s M&A activity in 2008 was almost equally split between purely domestic deals – where one Chinese company buys or merges with another – and the cross-border acquisitions where Chinese and foreign firms join together – either with the Chinese firm buying into the overseas business, or the foreign firm taking a stake in a Chinese one.  

I see huge scope for growth in both areas. China’s economy, though growing more slowly now than in recent years, is still expanding. Despite its vase size (China is now the world’s third-largest economy, trailing only Japan and the US) Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate. China’s private sector is filled with minnows, not whales. 

The result: there is ample room for consolidation in virtually every industry. Smaller firms will continue to merge, to gain both market share and scale economies. Strong regional companies will acquire competitors elsewhere in China to become national powerhouses. 

The M&A market, more than IPO activity, tends to holds up well even during sour economic times, or when stock markets fall. As share prices drop, the lower valuations make it cheaper for acquirers to act. We had evidence of this recently in the US, where one of the biggest M&A deals of all-time was recently announced: Pfizer’s planned acquisition of Wyeth Labs

In China, valuations for both quoted and private companies are lower than they were a year ago. That lowers the cost of acquiring a competitor. The cheapest way to build market share, at this point in China, will often be to buy it. 

All M&A transactions have risk. Very often, the planned-for gains in efficiency never materialize from combining two similar businesses. In China, the complexities go above and beyond this. There is due diligence risk – the difficulty of getting accurate financial information about an acquisition target – and management risk as well.  Good Chinese companies are  usually owned and run by a single strong Chairman, with scarce management talent around him. In a merger, the boss of the acquired company will often step aside, leaving a big hole in that company’s management, and so making it harder for the acquiring company to integrate its new acquisition. 

How to do M&A right in China? Good deal-structure and good advice are crucial. Structure can anticipate and resolve some of the larger post-acquisition headaches. Advice is important to make sure that the price and strategic fit are right. Just as China’s SMB’s need specialized merchant banks to serve their needs in raising capital, these SMBs, as they grow, will also need competent M&A advisors to identify target companies, manage the DD, do the valuation work, help negotiate the price, and assist with post-acquisition integration. 

Last year was a strong one for M&A in China. But, the future should be even brighter, once current economic uncertainty begins to abate.  Looking ahead, I see a real possibility that China’s M&A market will overtake America’s as the world’s largest. I’m planning for my company to play a part in this. 

Houlihan Lokey Founding Partner James Zukin Sets His Sights on China

February 9th, 2009 No comments

scholars-rock

 

I had the good fortune, while in LA, to have lunch recently with James Zukin. Jim is one of the name partners of the premier middle-market investment bank in the US, Houlihan Lokey Howard & Zukin. Jim and his partners were so far ahead of the curve, in spotting market opportunities, that they had to wait years for the curve even to appear behind them.

Over lunch, Jim explained how the firm stayed clear of Wall Street, both literally and figuratively, locating its headquarters in Los Angeles, and making the astute strategic decision to build a highly-focused and well-differentiated fee-based investment banking franchise, rather than an “all-purpose financial supermarket” that mixes advisory work with proprietary trading, market-making and IPO underwriting. We all know now how that supermarket model holds up over a full cycle: it doesn’t. The biggest of that breed, Merrill Lynch, sold out to Bank of America, and two other titans, Bear Sterns and Lehman Brothers, are both kaput.

Meantime, Houlihan Lokey (“HL”) has built and sustained a very successful business based first on providing fairness opinions and other valuation work, and then built up its lucrative practice advising on restructuring and M&A, and doing private placements. Even in dire financial times like now, HL continues to perform, doing solid, high-quality work a range of middle-market and SMB clients. HL again ranked as the number one firm in M&A advisory work in 2008 in deals of $2 billion or less, beating out Credit Suisse, Goldman Sachs, and others.

The race is won by the smart and focused, not the “supermarketized”.

Jim Zukin, no surprise, is the embodiment of the strategic qualities that have made his firm a consistent, anomalous success. A self-described “outsider”, he is by turns smart, charming, witty and modest. (Like me, he also likes a good burger.)

We met to talk about China, where Jim has personally spearheaded HL’s activities over the last few years, traveling back and forth frequently from LA, and opening offices in Beijing and Hong Kong. He speaks with palpable joy when discussing his visits to China. His workload at home in the US means fewer trips to China now, but he still refers to China, with heartfelt passion, as his “mistress.” It’s a description I’ve now shamelessly lifted from him, to describe my own long-term, requited love affair with China.

Jim Zukin is the one remaining “name partner” of Houlihan Lokey Howard & Zukin. He remains the chairman of Houlihan Lokey Asia. That’s a concrete sign of the company’s commitment to build a dynamic and durable business there.

HL has built a solid platform for growth in China. Its areas of expertise – and entrepreneurial outlook – position it well there. I know from my own experience that there is a sizable opportunity, to cite one example, to provide financial opinion, M&A and restructuring advisory work to the leading international PE firms active in China.

I have every reason to expect HL to succeed in China, with the same sort of approach that has worked so well for the firm in the US. How do they do it? Simple: Don’t run with the herd. Run with a better map.

A New Year of Challenges and Opportunities in China’ Private Equity Industry

February 7th, 2009 No comments

chin-amulet-wanli-taichang

Looking purely at the economic news from China of late, this has not been the happiest of Chinese New Years. The Chinese government is estimating that 16% of the huge migrant labor force of 200 million will have no job to return to after the New Year.  Factories are continuing to close, or cut employment, across the country. Guangdong province, where China First Capital has its base in China, is particularly hard hit, because it’s still the primary production base for much of China’s better private factories. While factories are being moved out of Guangdong to less expensive, inland locations like Jiangxi, overall industrial employment in factories in Guangdong is still huge, and hugely reliant on migrant labor. There’s no solid date, but ten million or more workers may have lost their jobs in Guangdong over the last six months. 

The picture is no less bleak in terms of projections for corporate profits in China in 2009. Larger companies are reporting profit falls of over 50% in 2008, and forecasting even worse results this year. This matters crucially in China. Over 40% of total economic output is generated by business investment. This, in turn,  is intimately tied to corporate profits, since most of that business investment is financed out of retained profits. According to a recent report in the Wall Street Journal, “official statistics show that 63% of investment in China last year was financed by what are called “internally generated” funds, which include retained profits. That’s up from just below 50% a decade ago.” 

In other words, as corporate profits decline, they take Chinese GDP growth with them. This falling economic output, in turn, influences consumer sentiment, and so takes personal spending down with it. 

Good economic news is a scarce commodity this Chinese New Year. But, I see one bright glimmer of hope here. Chinese companies have been excessively reliant on retained earnings and expensive bank debt to finance their growth, rather than equity capital. The difficult economic environment, in China and indeed worldwide, provides a good opportunity for better Chinese companies to reorient their method of financing capital investment and growth. It’s the right time to take on equity capital, and use it as a platform to continue to invest and grow, even if corporate profits are in cyclical decline. 

The Chinese companies that can raise equity finance will enjoy a significant financial advantage over competitors, and so be able to gain market share. Adding equity finance lets a company both lower its overall cost of capital, and also increase the amount of capital it can put to work in its business. Both of these factors equate to a very real competitive advantage. 

Equity investors, principally PE firms, will need to change their orientation as well. The opportunities to do shorter-term “pre-IPO” financing are far fewer than they were, because stock market valuations are way down and IPO activity has slowed to a crawl. So, the simple arbitrage of a PE firm buying into a Chinese company at a valuation, say, of 10x and selling out 18 months later in an IPO at 20x are gone. 

Instead, PE investors in China need to think more like value investors, and less like arbitrageurs. This means looking for opportunities to deploy capital into good businesses offering high rates of return on that invested capital. Equity investment is then used to expand output, lower unit costs, gain market share, and so expand both profits and profit margins. Build profits and valuation will take care of itself. If a Chinese company can put equity capital to work well, and accelerate profits in 2009 and beyond, that business will be worth a lot more money when the IPO market revives than if it simply cut back on investing to ride out the bad times. 

This year is going to be difficult, challenging, but also potentially highly rewarding for all of us participating in the financing of private companies in China. It’s a year when good companies should be able to get even better. And smart-money PE firms will make far more, over the medium-term, than fast-money valuation arbitrageurs ever did.