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How PE Firms Can Add – or Subtract – Value: the New CFC Research Report

August 8th, 2010 Leave a comment Go to comments

China First Capital research report

CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report

China is awash, as nowhere else in the world is,  in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China. 

In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the same”. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not. 

In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.

They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy. 

But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away? 

These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.

These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company. 

It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments. 

Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investors”.

Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.   

Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business.  In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.

chart1

The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.

While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment. 

In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO. 

At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention. 

The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.


 

  1. Chris
    August 9th, 2010 at 02:29 | #1

    Having now worked for 2 PE owned companies, I’m not convinced. It’s a very idealized view of how private equity should function and add value to growth enterprises.

    Yes, overall there is some improvement into the optics of the business (as viewed from a future investor point of view) but given how little time PE firms spend in the business (usually shouting at Board meetings), how little expertise and support is given in delivery, service, operations, sales & marketing (despite the claimed connections and alleged expert resources that PE firms have), how brutal they require management to become with the existing workforce, and how the real gain is primarily through financial engineering and tax minimisation, I think there are many better ways for growth businesses to finance themselves.

    In the diagram above, you point to a range of “value adds” that PE can deliver “sales growth”, “improved profitability”, “new technologies”, “establishing market leadership”, “improved accounting / reporting”, “margin improvements”. These improvements are delivered internally by the business not by PE. Yes, PE can force the business to focus on these issues (with a view to a future IPO) but any enterprise management looking to move from the entrepreneurial to the medium-size phase can and should do the same.

    None of these things are easy to do and moving from the entreprenteurial to the managed growth phase of a business is tough, involves significant investment in professional and management resources (which many entrepreneurs may find difficult to understand or accept).

    In my experience, the optical improvements made by PE to make the business more attractive to future investors were financed by the cashflow of the business itself NOT by PE’s initial or subsequent investment.

    I am highly sceptical of the alleged value adds of PE. Having been in a management role in 2 PE owned companies, I was quite surprised by how little of real value was delivered by PE. These firms were among the world’s Top 10 in one case and a large regional in another. Both have been highly commended and awarded in the PE / VC industry. Both made minimal on-going investment in business operations, took up only quick return and easy opportunities. They then onsold at a huge almost tax free profit.

    A Chinese entrepeneur would be better off funding business development and improvement themselves.

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