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China Investment Banking Case Study: An SOE Privatization

July 30th, 2013 4 comments


China First Capital Signing ceremony

Anyone who’s dipped into this blog will know that I rarely, if ever, discuss directly what me and my company China First Capital do, our client work. Partly it’s because the work is usually by necessity confidential (clients, investors, deal terms) and partly because I don’t blog as a marketing tool.

But, I plan over coming months to share significant details about a “live deal” we are now working on, a buyout transaction involving a Chinese state-owned enterprise (SOE). The reasons: its size and structure make it an unusual transaction in China, and one that might also bust some myths about the way business in China, especially involving SOEs, actually works.

While I can’t reveal the name of the company, I can disclose why I think it’s such a compelling deal.  Our client is one of China’s largest, most well-known and most successful SOEs. The group’s overall annual profit of over Rmb12 bn (about USD$2bn) also make it one of the richest. Unlike a lot of SOEs, this one operates in highly-competitive markets, and has nothing like a monopoly in China.

The deal we’re working on is to restructure then “privatize” two profitable subsidiary companies of this SOE. Both of these subsidiaries are the largest businesses in China in their industry. Their combined revenues are about $220mn.

Privatization has two slightly different meanings in Chinese finance. First, is the type of deal, very common a decade ago, where big SOEs like China Mobile, Sinopec, PetroChina, ICBC, Air China, are converted into joint stock companies and then a minority share is listed through an IPO on stock markets in China, US or Hong Kong. The companies’ majority owner remains the Chinese state, with the shares usually held and managed by a powerful arm of the government known in Chinese as 国资委, in English known as the State-owned Assets Supervision and Administration Commission, or more commonly SASAC. In theory, SASAC probably holds the world’s largest and most valuable share portfolio, far bigger than Fidelity,  Vanguard, or the world’s sovereign wealth funds.

The other, rarer,  type of privatization is where a company’s majority ownership changes hands, from state to private ownership. This is the type of control deal we are working on. The plan is to spin out the two subsidiaries by selling a majority stake to either a strategic or financial acquirer. In all likelihood, each company will one day go public either in China or Hong Kong, at which time, I’d expect their market caps to each be well over US$1bn.

In essence, the deals are structured as a recapitalization, where a new private-sector majority owner will contribute capital in excess of the company’s current assessed value. That valuation is determined by an independent accounting firm,  based on current asset value.

The privatization process is heavily regulated and tightly controlled by SASAC. It involves multiple levels of review, outside valuation, and then an open-market auction process. The system has changed out of all recognition from the first generation of government asset sales done in the 1990s. These deals involved little to no public disclosure or transparency and generated quite a lot of criticism and resentment that Chinese state assets were being sold to insiders, or the well-connected, for a fraction of their true value.

For an investment bank, working with an SOE, especially a large and famous one, has a process, logic and rhythm all its own. There are many more layers of management than at a typical Chinese private company, and many more voices involved in decision-making. In this case, we’re rather fortunate that the chairman of the holding company is also the founder of the two subsidiaries we’re now seeking to spin out. He started the companies from zero less than ten years ago, and has built them into proud, successful, fast-growing businesses.

This chairman has far more sway over the strategy and direction of the SOE than is usual in China. I first met him over a year ago. I was called to visit the company to explain the process through which an SOE like his could raise outside capital. Though curious, the chairman said at the time it seemed like more trouble than it would be worth. He had a comfortable life, and was nearing mandatory retirement age.

In fact, as I now understand, that first meeting was really just a way to kickstart a long, complicated and confidential discussion process involving the chairman, his senior management team, as well as even more senior officials at the SOE.  Over the course of a year, the chairman was able to persuade himself, as well as the many others with a potential veto, that a spin-out of the two companies was worth considering in greater detail.

The privatization offers the promise of long-term access to capital and also, most likely, a greater degree of management autonomy.  Though the two subsidiaries do not sell to, rely on or otherwise have related party transactions with the parent, they are ultimately subject to some rather heavy and often-stifling bureaucratic controls. Contrary to the reputation of many Chinese SOE, the two companies sell high-end products to large fastidious global customers. They operate in highly kinetic markets but with a corporate structure above them that is as slow, ponderous and impenetrable as a five-hour Peking Opera performance.

The chairman invited me to return for another visit in June. What followed was a rather intensive process of me and my team submitting several different financing plans and options, including the privatization of either the whole holding company or various subsidiaries, either as standalones, or grouped into mini-conglomerates. These different plans got discussed very actively inside the SOE. In under a month, the company had decided how it wanted to proceed: that its two strongest and most successful subsidiaries should be separately spun off and majority control in each offered to a new investor.

It may not sound like it, but one month is a remarkably fast time for an SOE to consider, decide and then get necessary approvals to do just about anything. We also work with another even larger Beijing-headquartered SOE and it took them almost four months to get the eleven different people needed to approve, and apply the chop to, our template Non-Disclosure Agreement.

I was summoned with one day’s advance notice to return to the company in late July to sign a cooperation agreement to advise them on the proposed privatization/recapitalization of the two subsidiaries. Again, that’s rather typical of SOEs:  meetings are called suddenly, and one needs to drop whatever one’s doing and attend. For me, that meant a hastily-booked two hour flight, then a three-and-a-half hour drive to the company’s headquarters. A photo from the signing ceremony is at the top of this page. (I have to cover over the name of the company.)

The contract signing was followed by another in a series of very elaborate and extremely tasty meals. The chairman has converted a 13-acre plot of the company’s land into an organic farm, where he grows fruits and vegetables and raises free-range pigs, ducks, chickens. Everything I’ve eaten while visiting the company has come from this farm. Everything is remarkably good. And, yes, along with the food, a rather large amount of Chinese alcohol is poured.

In future posts, I’ll talk about different aspects of the transaction, including how to parse the balance sheet and P&L of an SOE, as well as the industrial and investment logic of doing a takeover of an SOE. In the current market environment in China, where so many PE minority investments are stranded with no means to exit, there has probably never been a better time to do buyout transactions, particularly of mature and successful industrial companies with scale, good profit margins and clean accounting. Good businesses like this are few. We are now working for two of them.

 

 

Doostang Employer Spotlight: China First Capital

July 28th, 2013 No comments

Doostang - China First Capital

Doostang is a US career website frequently used by those with a recent MBA degree from Wharton, Stanford, INSEAD and some of the other better universities. They interviewed me about what we look for in new hires.

You can read the interview by clicking here.

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Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

July 23rd, 2013 1 comment

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

Separate Managed Accounts — A cure for what’s wrong with private equity in China?

July 10th, 2013 1 comment

Where is the PE industry headed in China? How can it rebuild from the current state of crisis with thousands of unexited investments and tens of billions in stranded LP money?  I have a suggestion. The future is separate managed accounts.

This is a form of institutional investing that is especially needed, and especially appropriate, in China. Separate managed accounts would give LPs what they want, access to good investment opportunities in China, but with little or none of the high risk, waste, misaligned incentives of “blind pool” investing in a typical PE firm in China. Separate managed accounts have the potential to fix what is manifestly broken in China private equity.

Briefly, separate managed accounts are an arrangement through which an LP hires an investment team, usually but not necessarily a PE firm, to manage money directly on its behalf, rather than put money into a larger bucket (a typical PE or VC fund) alongside other LPs. That’s the way the system generally works now — PE firms pool money from LPs large and small, build and manage a single “all-purpose” portfolio. LPs, even the largest ones,  all pay pretty much the same annual management fee (around 2%) and surrender the same share of accumulated profits (usually 20% and up) to the team investing the money.

From an LP perspective, the advantages of a managed account are numerous. The three key ones are lower fees, greater ability to hold the investment team accountable,  and a portfolio more specially tailored to its needs, including the timing of liquidity events. In private equity terms, separate managed accounts are more like no-load index funds than fat-fee mutual funds. Leverage and gains are transferred to the people whose money is at risk, not the ones who manage it.

The private equity industry is as ripe for this kind of disruption as the mutual fund industry was in the 1970s when John Bogle (a genuine hero of mine) began offering index funds at Vanguard. Bogle stripped out most of the fees and overheads charged by traditional mutual fund companies, and so let investors keep more of what they earned. He showed that paying “superstar fund managers” to build a portfolio was usually nothing more than a colossal waste of money.

Bogle’s ideas and business model took awhile to catch on. The traditional mutual fund industry fought it every step of the way. But, today, Vanguard is the largest, as well as the most admired mutual fund company in the world. John Bogle hasn’t gotten particularly rich doing this. But, he has made millions of dollars for millions of others.

My guess is if John Bogle and Vanguard wanted to get into private equity, they would set up a business to provide separate managed accounts. The “two-and-twenty” approach of most PE and VC firms has come under increasing pressure everywhere. LPs, often with large unfunded liabilities, are under ever greater pressure to improve returns.

Overall, PE and VC has a pretty good record of producing returns above the basic hurdle rate of around 5-8% a year. This is especially true when returns are based on a PE firm’s own “marked-to-market” valuations. Actual cash-on-cash returns are usually lower, because exits are not common enough.

Once you subtract the GP’s fees and cut of the profits, an LP’s returns, especially when you factor in a liquidity premium,  is often not a lot to get excited about.  For LPs, cash returns are what matter most. Pension funds and insurance companies need to disperse real cash every month, not marked-to-market audit statements of a PE fund’s notional investment returns.

If done well, an LP investing through a separately managed account can get all the performance and diversification benefits of PE investing, but at lower cost, with greater control, both over the outlays of cash and the kind of deals being done. In China, the appeal of separately managed accounts should be particularly strong. We’re now seeing — and LPs feeling most of the pain — of the problems, distortions and heavy risks inherent in the current model of private equity in China.

PE firms raised tons of money by rightly pointing to China’s attractions as an emerging market — huge population and market, with economic growth far higher than in Europe and the US, and a large number of strong, private sector companies hungry for capital.   There was also a legacy of very lucrative PE deals done during the industry’s early years in China, including investments in China’s main search company Baidu, as well as Shenzhen Commercial Bank, Pingan Insurance.

To gain access to Chinese investment opportunities, LPs were persuaded to accept a level of risk that they might ordinarily shun. PE investing in China, they were told, is different, with opaque regulations, shifting government policies, a business environment rife with corruption and cronyism, primitive capital and debt markets. The PE and VC firms were often either newly-formed, or familiar names (like Kleiner Perkins, Sequoia, KKR) staffed with local Chinese-speaking teams who operated more like franchisees.

Hundreds of PE firms crowded into China. Almost all chose to adopt the identical investment strategy and target the same kinds of companies — those that looked the likeliest to have an IPO. Two hundred billion dollars was poured into over 10,000 Chinese companies. It turned out in many cases to be among the blindest forms of blind pool investing ever — a lottery ticket strategy in search of lottery returns.  The result is $100bn or more of LP capital now stranded inside illiquid investments. A large proportion of these deals will likely not exit before the expiry date of the fund. That represents a serious problem for LPs.

For most LPs, liquidity is a paramount concern. PE investing in China seems to have lost sight of that, with its reliance on IPOs as a single unhedged exit strategy. Even at its high point six years ago, IPOs were a low probability outcome. Fewer than half the PE deals done in 2007 exited through IPO. Following that, the number of deals done each year grew by over 50% from the 2007 amount, while the number of IPOs peaked in 2010.

Incentives don’t often get more perversely misaligned than those between PE firms in China and the LPs they invested for. The PE firms got fees, profit shares and very little scrutiny. Once a year or so, they marked-to-market their illiquid investments. This helped persuade LPs all was well. In my experience, China GPs often focused more on keeping the fees coming in, including by continuously raising money,  and less on achieving reliable and timely exits for current LPs.

Had LPs been investing through separate managed accounts, there is far less likelihood any of this would have occurred. The LPs would have assessed more closely each deal that was being done, and put money only into deals that closely matched the LPs specific appetite for risk and timetable for achieving liquidity.

Better safeguards would have likely been put in place to make sure investments had a “put clause” that was more enforceable than the one used in the majority of PE deals in China. Done properly, the “put” allows an investor to sell shares back to the company after several years if all other exit channels are blocked. In other words, it places front and center, in any PE deal, that eventual liquidity is a minimum requirement.

LPs accept that investing in private equity and venture capital carries higher risks than buying publicly-traded securities. They also know that every PE portfolio will have its share of losers. But, where China PE is unique is in having such a high percentage of investments in flourishing businesses where the PE stake is illiquid, and unliquidatable within the remaining life of the fund.

In many cases, the investee companies used the PE money wisely, and have grown in the years since. They might like to have an IPO at some point, of course, but it isn’t necessary for their survival. The PE money is stuck inside. It’s not yet a crisis for the company. It is a crisis for the PE firms, and even more for the LPs, since it’s their money that’s now unrecoverable.

As a rule, the fees paid to managers for separate managed accounts are lower than those paid to a GP.  The profit carry is also usually lower. The spread between gross and net returns will be far narrower.  This will help LPs close what, for many, is a widening gap between current performance and future unfunded liabilities.

Although separate managed accounts seem an ideal business model for alternative investing in China, it may prove extremely difficult for LPs to find competent firms to provide the service. The economics of a typical PE fund are, of course, far more favorable for GPs than LPs. Separate managed accounts would reverse this.

John Bogle built the world’s largest and most successful mutual fund company by putting investors first, by chopping out wasteful fees, hidden charges, huge salaries, bonuses and overheads. He saw what was wrong with the mutual fund industry, that it was achieving mediocre results for investors while making huge piles of money for itself. He met a need, and for forty years now, he and Vanguard have done well by those who trusted them with their money.

China private equity needs a John Bogle. Will it get one?