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

April 25th, 2013 No comments

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

Shenzhen: A beacon for private enterprises — China Daily

April 22nd, 2013 No comments


 

A beacon for private enterprises

2013-04-20

By Hu Haiyan and Chen Hong ( China Daily)

Shenzhen bears a superficial resemblance to Shanghai. There are dozens of multinationals and gleaming skyscrapers casting their shadows over narrow lanes. Their respective economic performances last year were also similar: Shenzhen’s GDP hit 1.3 trillion yuan ($210 billion), gaining by 10 percent from 2012. Shanghai GDP reached 2 trillion yuan, increasing by 7.5 percent from 2011.

Both are testing grounds for China’s economic reform policies. Still, for Peter Fuhrman, 54, Shenzhen is a private-sector city, a city that has its face pointed toward the future.

In 2009, Fuhrman moved to Shenzhen from California. The chairman and CEO of China First Capital, an international investment bank and advisory firm focused on China, he is always struck by how similar Shenzhen and California are.

“Both are places where new technologies, and valuable new technology companies, are born and nurtured. I treasure the role Shenzhen has played over these last 30 years in helping architect a new China of renewed purpose and importance in the world,” Fuhrman says. “It is impossible to imagine a US without California. It is so much the source of what makes America great. Shenzhen, too, is a major source of what makes China great, what makes this country such a joy for me to live in. “

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Download PDF version.

 


China’s GPs search for exits — Private Equity International Magazine

April 18th, 2013 No comments

Chinese GPs are running low on exit options, but the barriers to unconventional routes – like secondary sales to other GPs – remain high.

By Michelle Phillips

China’s exit woes are no secret. With accounting scandals freezing the IPO route both abroad and domestically, the waiting list for IPO approval on China’s stock exchanges has come close to 900 companies.  Fund managers have at least 7,550 unexited investments worth a combined $100 billion, according to a recent study by China First Capital. However, including undisclosed deals, the number of companies could be as high as 10,000, says CFC’s founder and chairman Peter Fuhrman.
CITIC Capital chief executive Yichen Zhang told the Hong Kong Venture Capital Association Asia Private Equity Forum in January that because many GPs promised high returns in an unrealistic timeframe (usually three to five years), LPs were already starting to get impatient. He also predicted that around 80 percent of China’s smaller GPs would collapse in the coming years. “The worst is yet to come,” he said.
What ought to become an attractive option for these funds, according to the CFC study, are secondary buyouts. Even if it lowers the exit multiple, secondaries would provide liquidity for LPs, as well as potentially giving the companies an influx of cash, Fuhrman says.

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Private Equity Secondaries in China: Hold Periods, Exits and Profit Projections

April 11th, 2013 No comments

How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital’s latest research note. An abridged version is available by clicking here. Titled, “Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity” the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital’s path-breaking research  to measure the scale of the problem of unexited PE investments in China,  and to illuminate strategic alternatives for GPs investing in China.  China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, “these [hold period and investment return] models tend to support the thesis that “Quality Direct Secondaries”  currently offer the best risk-adjusted opportunities in China’s PE asset class.”  Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

“Until recently,” the China First Capital report points out, “private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year.  Those assumptions on valuation differentials as well as hold period are no longer valid.”

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China’s still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

  1. IPO
  2. Trade sale / M&A
  3. Secondary sale
  4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. “Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals.”

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only,  option available for a PE firm with diminishing fund life. “Buyers of these direct secondaries will not avoid or outrun exit risk,” the report advises. “It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund’s hold period. ”

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China “Quality Secondaries” offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure,  are not available in the abridged version.

 

 

Goldman Sachs Predicts 349 IPOs in China in 2013 — Brilliant Analysis? Or Wishful Thinking?

April 2nd, 2013 No comments

We’re one-quarter of the way through 2013 and so far no IPOs in China. Capital flows to private companies remain paralyzed. Never fear, says Goldman Sachs. In a 24-page research report published January 23rd of this year (click here to read an excerpt), Goldman projects there will be 349 IPOs in China this year, a record number. Its prediction is based on Goldman’s calculation that 2013 IPO proceeds will reach a fixed percentage (in this case 0.7%) of 2012 year-end total Chinese stock market capitalization.

This formula provides Goldman Sachs with a precise amount of cash to be raised this year in China from IPOs: Rmb 180bn ($29 billion), an 80% increase over total IPO proceeds raised in China last year. It then divvies up that Rmb 180 billion into its projected 349 IPOs,  with 93 to be listed in China’s main Shanghai stock exchange, 171 on the SME board in Shenzhen, and 85 on the Chinext (创业板)exchange. To get to Goldman’s numbers will require levels of daily IPO activity that China has never seen.

The report features 35 exhibits, graphs, charts and tables, including scatter plots, cross-country comparisons, time series data on what is dubbed “IPO ratios (IPO value as % of last year-end’s total market cap)”. It’s quite a statistical tour de force, with the main objective seeming to be to allay concerns that too many new IPOs in China will hurt overall China share price levels. In other words, Goldman is convinced a key issue that is now blocking IPOs in China is one of supply and demand. The Goldman calculation, therefore, shows that even the 349 new IPOs, taking Rmb180 billion in new money from investors, shouldn’t have a particularly adverse impact on overall share price levels in China.

I’ve heard versions of this analysis (generally not as comprehensive or data-driven as Goldman’s) multiple times over the last year, as China IPO activity first slowed dramatically, then was shut down completely six months ago. The CSRC itself has never said emphatically why all IPOs have stopped. So, everyone, including Goldman,  is to some extent guessing. Goldman’s guess, however, comes accessorized with this complex formula that uses December 31, 2012 share prices as a predictor for the scale of IPOs in 2013.

I’m grateful to a friend at China PE firm CDH for sending me the Goldman report a few days ago. I otherwise wouldn’t have seen it. I’m not sure if Goldman Sachs released any follow-up reports or notes since on China IPOs. Goldman was the first Wall Street firm to win an underwriting license in China. It’s impossible to say how much Goldman’s business has been hurt by the near-year-long drought in China IPOs.

Goldman shows courage, it seems to me, in making a precise projection on the number of IPOs in China this year, and relying on their own mathematical equation to derive that number. Here’s how all IPO activity in China since 1994 looks when the Goldman formula is plotted:

 

 

 

 

 

 

 

 

 

 

 

I’m not a gambling man, and personally hope to see as many IPOs as possible this year of Chinese companies. Even a fool knows the easiest way to lose money in financial markets is to be on the other side of a bet with Goldman Sachs. That said, I’m prepared to take a shot.  I’d be delighted to make a bet with the Goldman team that wrote the report. A spread bet, with “over/under” on the 349 number. I take the “under”. We settle up on January 1, 2014. Any takers?

My own guess – and that’s all it is –  is that there will be around 120 IPOs in China this year. But, this prediction admittedly does not rely on any formula like Goldman Sachs and so lacks exactitude. In fact, I approach things from a very different direction. I don’t think the only, or even main,  reason there are no IPOs in China is because of concerns about how new IPOs might impact overall share prices.

I put as much, or more, importance on rebuilding the CSRC’s capacity to keep fraudulent companies from going public in China. The CSRC seems to have had quite stellar record in this regard until last summer, when a company called Guangdong Xindadi Biotechnology got through the CSRC approval process and was in the final stages of preparing for its IPO. Reports in the Chinese media began to cast doubt on the company and its finances. Within weeks, the Xindadi IPO was pulled by the CSRC. The company and its accountants are now under criminal investigation.

The truth is still murky. But, if press reports are to be believed, even in part, Xindadi’s financial accounts were as fraudulent as some of the more notorious offshore Chinese listed companies like Sino-Forest and Longtop Financial targeted by short sellers and specialist research houses in the US.  The CSRC process — with its multiple levels of “double-blind” control, audit, verification —   was designed to eliminate any potential for this sort of thing to happen in China’s capital markets.

But, it seems to have happened. So, in my mind, getting the CSRC IPO approval process back on track is a key variable determining when, and how many, new IPOs will occur this year in China. This cannot be rendered statistically. The head of the CSRC was just moved to another job, which complicates things perhaps even more and may lead to longer delays before IPOs are resumed and get back to the old levels.

How far is the CSRC going now to try to make its IPO approval process more able to detect fraud? It has instructed accountants and lawyers to redo, at their own expense, the audits and legal diligence on companies they represent now on the CSRC waiting list.  Over 100 companies just dropped off the CSRC IPO approval waiting list, leaving another 650 or so stranded in the approval process, along with the 100 companies that have already gotten the CSRC green light but have been unable to complete their IPO.

A friend at one Chinese underwriter also told us recently that meetings between CSRC officials, companies waiting for IPO approval and their advisers are now video-taped. A team of facial analysis experts on the CSRC payroll then reviews the tapes to decide if anyone is telling a lie. If true, it opens a new chapter in the history of securities regulation.

If, as I believe,  restoring the institutional credibility of the CSRC approval process is a prerequisite for the resumption of major IPO activity in China, a statistical exhibit-heavy analysis like Goldman’s is only going to capture some, not all, of the key variables. Human behavior, fear of punishment, organizational function and dysfunction, as well as darker psychological motives also play a large role. An expert in behavioral finance might be more well-equipped to predict accurately when and how many IPOs China will have this year than Goldman’s crack team of portfolio strategists.