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Beyond the Hype, Shenzhen Qianhai Economic Zone — Article in AVCJ Magazine

August 31st, 2013 No comments

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AVCJ China First Capital

 

 

The Qianhai economic zone in Shenzhen is being primed as China’s next global financial services hub, a place where private equity firms can raise local currency funds from overseas investors. How is it getting on?

A small but burgeoning town on the outskirts of Shenzhen, Qianhai already has a fulsome epithet to which it can aspire – the “Manhattan of the Pearl River Delta.” With an imposing urban skyline sketched on architects charts and potentially even bolder financial reforms in the pipeline, local residents are quick to draw parallels between iconic downtown New York and ambitions writ large on the walls of the well-appointed Qianhai Authority Bureau Office.

The reality – a 15 square-kilometer site that is still basically a muddy piece of muddy reclaimed land – reminds visitors of just how far this economic zone has to go.

Much the same can be said of Qianhai’s attention-grabbing financial initiative: allowing renminbi to flow freely across the boundary with Hong Kong. This latest effort to internationalize China’s currency will, in theory, see locally-registered companies receive renminbi-denominated loans from Hong Kong banks, and locally-registered private equity funds raise renminbi capital from Hong Kong investors.

Several high-profile PE players have already bought into the idea. The Blackstone Group and KKR have reportedly held preliminary talks with the Qianhai authorities; John Zhao, CEO of Hony Capital, expressed interest in raising his next local currency fund via Qianhai; and Yawei Wang, who built a reputation as one of China’s top stock pickers during a 14-year career as a mutual fund manager with China Asset Management, registered a company in the zone.

But there remains a lot of talk and little action. Yung-Hoi Tse, chairman of Hong Kong-based BOCI-Prudential Asset Management, who also served as a consultant in the Qianhai Advisory Committee, attributes this to a lack of clarity as to what can be done with capital once it gets there.

“It is still a small universe because the offshore renminbi can only be invested in Qianhai as it stands,” Tse says. “Foreign enterprises expect to be able to ramp up their business and investments in Shenzhen, and in neighboring cities in Guangzhou province, later on. However, there is still uncertainty because no detailed rules have been introduced.”

This means a Hong Kong bank can lend to property developers responsible for building Qianhai, but not to those operating elsewhere. Similarly, a private equity firm could deploy its newly raised renminbi corpus in local companies, but no further. Little wonder they are still sitting on the sidelines.

A bright idea

Unveiled three years ago, the Qianhai Shenzhen-Hong Kong Modern Service Industry Cooperation Zone is intended to be part-port, part-trading hub, an integrated financial services, logistics and information technology platform on the threshold of China, just half an hour’s drive from Hong Kong. A total of $45 billion has been earmarked for the project.

As an added sweetener for the financial sector, firms that set up shop in Qianhai will receive tax breaks and permission to issue renminbi-denominated bonds.

The problem is China’s economic zones are no longer that special – there are too many of them and they offer similar incentives packages. President Xi Jinping chose to visit Qianhai on his first official trip outside Beijing in January, so clearly there is high-level support. And the new economic zone clearly wants to leverage Hong Kong’s financial strength and status as an offshore renminbi center. But can the magic last?

Seven years ago, Binhai New Area in Tianjin municipality became China’s first testing bed for financial services reforms. Located by the Bohai Sea, Binhai was supposed to replicate development seen in Shenzhen and Shanghai’s Pudong New Area. This coincided with the emergence of domestic private equity and it led to the creation of Bohai Industrial Investment Funds, a vehicle backed by a slew of state-owned enterprises that invested in small-scale high-tech manufacturing businesses.

Tianjin won its own epithet – the “private equity paradise” – thanks to tax incentives and easier registration processes. However, loose controls have proved liberating and limiting, with thousands of individual investors – who suffered losses after investing in unqualified managers – taking to the streets in protest at what they saw as poor government oversight of fundraising.

“Each local government has been aggressively looking to the central government to approve preferential policies, in particular to attract private equity investment,” says Frank Han, executive director at Bohai Industrial Investment Fund Management. “Qianhai was doing a massive amount of PR work last year. However, what they have is just a regulatory framework with no detailed implementation rules.”

As such, Qianhai risks running into the same problem as Tianjin – aggressively promoting the industry while underlying policy is uncertain and inadvertently straying beyond the central government’s comfort zone.

Replicating the success of Tianjin will also be difficult because the industry has changed enormously since 2006, when to all intents and purposes domestic private equity did not exist. By contrast, Qianhai’s renminbi fundraising initiative was announced at a time when local managers had no trouble attracting capital.

Had the astonishing highs of 2011 been maintained – $32.2 billion went into 235 renminbi funds in 2011 – or moderated slightly, by now firms might have been expected to be laying the groundwork. Instead, they are fighting for survival. Hurt by uncertainty in the IPO market, 46 local funds attracted just $8.9 billion in commitments in the first seven months of 2013.

“Long term, China private equity should have an outstanding future and Qianhai should become an important cluster of investors, bankers, lawyers and accountants. By an accident of timing, however, Qianhai launched during a time of unprecedented crisis and downturn in China PE,” says Peter Fuhrman, chairman and CEO of Shenzhen-based China First Capital.

Limited activity

This state of affairs has no doubt contributed to the slow pick up in Qianhai. About 600 enterprises have registered to open offices in the zone, 70% of which are financial institutions, including a handful of private equity firms.

To date, Shenzhen Raytai Fund Management is the only one to raise a fund domiciled in Qianhai, targeting RMB10 billion ($1.63 billion) over a seven-year period (investments will be made concurrently). The firm was aiming for a first close of RMB10 million but reduced it to RMB5 million, with more than a half the capital coming from the GP’s own coffers.

“We see the IPO hiatus as a chance to make good M&A investments,” says Peter Kwong, a partner at the firm. “A lot of enterprises are under pressure to exit, having agreed to valuation adjustment mechanisms with PE investors, which guarantee a certain level of return from an IPO within a short period of time. We will buy majority stakes in these companies and exit them to listed companies that are looking to expand.”

According to the Qianhai registration center, only five foreign private equity firms have filed for permission from the Shenzhen government to raise offshore renminbi in Hong Kong. Their caution is rooted in uncertainty – about investment restrictions and, by extension, how big the Qianhai project could actually become.

“What does Qianhai have to offer that other places in China cannot? If it’s only the possibility for some offshore renminbi to come back legally into China, then that’s a bit of a damp squib.” a China-focused GP says. “That could happen anywhere, with the right policy, or everywhere once the renminbi becomes fully convertible.”

Hong Kong investors are more sophisticated than their mainland counterparts and have access to global markets. In this context, a fund that only invests in a particular Shenzhen district might not be attractive.

Furthermore, it is unclear whether the enterprises engaged in cross-border trading that hold most of the renminbi in Hong Kong would be interested in private equity at all. The traditional target investors – financial institutions – are subsidiaries of overseas entities and fund managers are skeptical of how much renminbi they could raise from local institutions.

“The Hong Kong subsidiaries of Chinese banks have large renminbi deposit bases, but they can’t invest in private equity. Large Chinese enterprises would have to be the primary fundraising targets,” says S.C. Mak, founding partner of Hong Kong-based Fuel Capital.

Foreign or local?

Another problem is that renminbi vehicles that include capital from offshore sources don’t qualify for local treatment on investments.

This is an extension of the “Blackstone guidance” issued in 2012. Following the introduction of the Qualified Foreign Limited Partnership (QFLP) program, which allows foreign capital to be channeled into renminbi vehicles, the Shanghai government said these funds would be able to operate on an equal footing with local players if less than 5% of the total corpus came from overseas. This implied less bureaucracy slowing down approvals and fewer restrictions on target investment areas.

However, when The Blackstone Group asked for clarification on this point, the National Development and Reform Commission indicated that local treatment would not apply to Blackstone “and this type of situation where the GP is foreign-invested.”

This has hampered the fundraising hopes of renminbi vehicles launched by global PE firms. The expectation is the same would apply to funds domiciled in Qianhai, which also operates a QFLP program.

BOCI’s Tse links the restrictions to wider government concerns about controlling inflows of speculative “hot money” that have the potential to destabilize the economy.

“They want to keep record of how that foreign capital is being used in the country and whether they are really supporting China’s physical economic growth,” he says. “Even though Qianhai is more convenient for foreign exchange conversion, every project is still examined by the regulator on deal-by-deal basis. This will dampen foreign investors’ appetite.”

Although plenty of companies have registered to open offices in Qianhai, so far none are in operation, which means investment targets are limited – unsurprising given the zone is still in its nascent stages.

There are plans for infrastructure that can support small- and medium-sized enterprises (SMEs). Three months ago, the Qianhai Equity Exchange launched with the bold ambition to become Shenzhen’s biggest over-the-counter exchange. Companies do not require administrative approval to list, there are no custodial fees or mandated changes in corporate structure, and information disclosure is limited.

More than 1,700 SMEs have listed via the online platform, but VC investors are unconvinced by it as a source of deals.

“It won’t help fund managers. Professional investors tend to work on their own targeted deal flows, which usually stay low-profile. Once a start-up is put online and enters the public domain the valuation jumps to a very high level. Investors therefore might not want to compete for these deals,” says York Chen, president and managing partner of iD TechVentures.

Even the tax breaks available to certain industries in Qianhai have drawn skepticism from some quarters. The corporate income tax rate has been set at 15%, compared to 25% nationally, and there are also plans to lower personal income tax rates for financial services professionals. Other cities in China have made similar promises but Danny Po, Asia Pacific and China national leader of M&A tax services at Deloitte, argues that comparisons should really be drawn with what is available to foreign PE firms offshore.

“In cases where a fund is managed entirely from offshore, it is only required to pay a withholding tax of 10% and zero corporate income tax because its tax transparent structure,” he explains. “As for individual income tax reductions, it really comes to a question of how much of a foreign executive’s income is driven by China business. If his salary is mostly generated from overseas operations, it isn’t important.”

Although the current prognosis might be negative, Qianhai remains a work in progress. Given a more favorable renminbi fundraising environment and a clear set of rules supporting the financial services industry, the project could still fly. The former is difficult to remedy but the latter can be addressed through more lobbying of the central government.

There is no doubt that Qianhai is well positioned to serve as a testing bed for capital account liberalization and currency convertibility, by which point the current rigid line between foreign and domestic investment will blur.

A number of industry participants therefore prefer to treat Qianhai as a broader financial sector play rather than a solely private equity phenomenon – not just because of government incentives for setting up financial institutions in the zone, but also because of the immense opportunities offered by China’s asset management sector.

“A rising tide lifts all boats,” adds Zhang Ying, counsel at domestic law firm Fangda Partners. “The developments in the onshore asset management sector will create a conducive macro environment for onshore private equity fundraising and investments.”

 

Why China PE will rise again — Interview in China Law & Practice Annual Review 2013

August 23rd, 2013 2 comments

CLP

 

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Peter Fuhrman, chairman of China First Capital, talks to David Tring about his company’s disciplined focus, what the IPO freeze means for PE investors and how a ruling from a court in China has removed a layer of safety for PE firms

What is China First Capital?

China First Capital is a China-focused international bank and advisory firm. I am its chairman and founder. Establishing, and now running, China First Capital is the fulfilment of a deeply-held ambition nurtured for over 30 years. I first came to China in 1981, as part of a first intake of American graduate students in China. I left China after school and then built a career in the US and Europe. But, throughout, I never lost sight of the goal to return to China and start a business that would contribute meaningfully and positively to the country’s revival and prosperity.

China First Capital is small by investment banking industry standards. Our transaction volume over the preceding twelve months was around $250 million. But, we aim to punch above our weight. China First Capital’s geographical reach and client mandates are across all regions of China, with exceptional proprietary deal flow. We have significant domain expertise in most major industries in China’s private and public sector, structuring transactions for a diversified group of companies and financial sponsors to help them grow and globalise. We seek to be a knowledge-driven company, committed to the long-term economic prosperity of Chinese business and society, backed by proprietary research (in both Chinese and English), that is generally unmatched by other boutique investment banks or advisory firms active in China.

What have been some of the legislative changes to the PE sector this year that are affecting you?

The recent policy and legislative changes are mainly no more than tweaks. There has been some sparring within China over which regulator would oversee private equity. But, overall, the PE industry in China is both lightly and effectively regulated. A key change, however, occurred through the legal system within China, when a court in Western China invalidated the put clause of a PE deal done within China, ruling that the PE firm involved had ignored China’s securities laws in crafting this escape mechanism for their investment.  While the court ruled on only a single example, the logic applied in this case seems to me, and many others, to be both persuasive and potentially broad-reaching. For PE firms that traditionally added this put clause to all contracts they signed to invest in Chinese companies, and came to rely on it as a way to compel the company to buy them out after a number of years if no IPO took place, there is now real doubt about whether a put clause is worth the paper it’s printed on. Simply put, for PE firms, it means their life-raft here in China has perhaps sprung a leak.

What are some of the hottest sectors in China that are attracting PE investors?

At the moment, with IPOs suspended within China and Chinese private companies decidedly unwelcome in the capital markets that once embraced them by the truckload – the US and Hong Kong – there are no hot sectors for PE investment in China now. The PE industry in China, once high-flying, is now decidedly grounded and covered in tarpaulin. What is perhaps most unfortunate about this is that what we are seeing mainly is a crisis within China’s PE industry, not within the ranks of China’s very dynamic private entrepreneurial economy. In other words, while financing has all but dried up, China’s private companies continue, in many cases, to excel and outperform those everywhere else in the world. The PE firms made a fundamental miscalculation by pouring money into too many deals where their only method of exit, of getting their money back with a profit, was through an IPO. By our count, there are now over 7,500 PE-invested deals in China all awaiting exit, at a time when few, if any exits are occurring. Since PE firms themselves have a finite life in almost all cases, this means over $100bn in capital is now stuck inside deals with no high-probability way to exit before the PE funds themselves reach their planned expiry. The PE industry has never seen anything quite like what is happening now in China.

What is a typical day like for you at China First Capital?

We are lucky to work for an outstanding group of companies, mainly all Chinese domestic. Indeed, I am the only non-Chinese thing about the business. I am in China doing absolutely what I love doing. There are no aspects of my working day that I find tedious or unpleasant. Even at my busiest, I am aware I am at most a few hours away from what the next in an endless series of totally delicious Chinese meals. That alone has a levitating effect on my spirit. But, the real source of pleasure and purpose is in befriending and working beside entrepreneurs who are infinitely more skilled, more driven and wiser to the ways of the world and more successful than I ever could hope to be.

We are quite busy now working for one of China’s largest SOEs. It’s something of a departure for us, since most of our work is with private sector companies. But, this is a fascinating transaction that provides me with a quite privileged insider’s view of the way a large state-owned business operates here in China, the additional layers of decision-making and the unique environment that places far greater onus on increasing revenues than profits.

What do you find are some of the major issues or concerns for foreign PE clients when doing deals in China?

All investors looking to make money in China, whether on the stock market or through private equity and venture capital,  must confront the same huge uncertainty – not that China itself will stop its remarkable economic transformation and stop growing at levels that leave the rest of the developed world behind in the dust. This growth I believe will continue for at least the next 20 years. The big unknown has to do with the actual situation inside the Chinese company you are buying into. Can the financial statements and Big Four audits be relied on? Are the actual profits what the company asserts them to be? How great is the risk that investors’ money will disappear down some unseen rat hole?

Some frightening stories have come to light in the last two years. How widespread is the problem of accounting fraud in China? Part of the problem really is just the law of big numbers. With a population almost triple that of the US and Western Europe combined, China has a lot of everything, including both remarkable businesses run by individuals who are the entrepreneurial equal of Henry Ford and Steve Jobs, and well as some shady operators.

What is your outlook for China’s PE sector in the coming 12 months?

I believe the current crisis will abate, and stock markets will once again welcome Chinese private sector companies to do IPOs. The IPOs will be far fewer in number than in 2010, but still the revival of IPO exits will also thaw the current deep-freeze that has shut down most PE activity across China. PE firms will again start to invest, and put a dent in the $30 billion or more in capital they have raised to invest in China but have left untouched. The PE industry in China, since its founding a little more than a decade ago, grew enormously large but never really matured. There are now too many PE firms. By some count, the number exceeds 1,000, including hundreds of Renminbi PE firms started and run by people with no real experience investing in private companies. Their future appears dire. At the same time, the global PE firms that bestride the industry, including Carlyle, Blackstone, TPG, KKR, have yet to fully establish they can operate as efficiently and profitably in China as they do in Europe and the US.

While the China PE industry struggles to recover from many self-inflicted wounds, China’s private sector companies will continue to find and exploit huge opportunities for growth and profit in China, as the nation’s one billion consumers grow ever-richer and ever more demanding.

 

China SOE Accounting — BAAP Not GAAP Applies

August 15th, 2013 No comments

China SOE accounting

If the last two years of crisis in investing in Chinese companies proves anything, it’s that any Chinese company that pays more tax than it should, documents every transaction and practices the most forensic accounting methods is the one with the calmest, happiest investors. Such companies are very rare among the thousands invested in by private equity, and not very common among publicly-traded ones,  if professional short-sellers like Muddy Waters, as well as securities regulators in the US and Hong Kong are to be believed.

Chinese companies, especially private ones,  live under a cloud of suspicion their books are cooked, while their auditors turn a complicit blind eye. While that cloud hovers, it will remain impossible for Chinese private companies in large numbers to successfully sell their shares to the public through an IPO. Chinese companies already listed are not much better off. For many, their share prices remain seriously depressed because of investor doubts about the accuracy of the financial accounts.

For PE firms, it represents a very painful dilemma. To have any chance to IPO, their portfolio companies will often need to pay more tax. But, doing so makes the companies less profitable and so much less attractive to the capital markets. Pay first and pray for an IPO later is pretty much the current PE exit strategy in China.

What a refreshing change, therefore, it is to encounter the financial accounts of a Chinese state-owned enterprise (“SOE”). By Chinese standards, their accounts are often clean enough to eat off. SOEs often seem to take pride in paying as much tax as possible. Rather than hiding income, they seem to want to exaggerate it.

Why do SOEs operate this way? It could be argued that tax-paying is their form of national service. Most SOEs pay no dividends to the state, even though the state is the majority, indeed often the 100% owner. Or perhaps SOEs are trying to set a righteous, though generally ignored, example of dutiful tax compliance?

In fact, the heavy and perhaps over-scrupulous tax-paying can also be seen as the result of a system of diligent, almost fanatical record-keeping practiced inside SOEs. Everything bought or sold, every Renminbi moving inside or outside,  is tabulated by the SOEs large team of in-house bookkeepers. Note, I say bookkeepers, not accountants. An SOE has many of the former and few, if any, of the latter.

That’s because SOEs also operate by their own set of accounting standards. I call it “Chinese BAAP“, or “bureaucratically accepted accounting principles“. This is, needless to say, as different from GAAP as any two financial tracking systems could possibly be.

Under Chinese BAAP, the purpose of the annual financial statement is to produce a record that bureaucratic layers above can use. This means especially the administrators at SASAC, the government agency that owns and manages most SOEs. SASAC’s job is to make sure that SOEs are (a) increasing output while operating profitably; and (b) not engaged in any kind of corrupt hanky-panky.

Of the two, SASAC is probably more concerned that government property is not being pilfered, misappropriated, wasted or diverted to pay for senior management’s weekend gambling junket to Macao. This isn’t to say that such things can’t occur. But, the accounting system used by an SOE is designed to be so meticulous, so focused on counting and double-counting, that bad acts are harder to do and harder to hide.

If I could bill out all the time I’ve personally spent during 2013 studying and complying with SOE payment procedures, I’d probably have at least 100 billable hours by now. I should bill the SOE for all this time, but figuring out how to do so would probably take me another 60 hours.

The main purpose of all the rules seems to be to keep a very solid tamper-proof paper trail of money leaving the SOE. This is a far cry, of course, from accounting, at least as its understood outside China. The way assets are valued, and depreciated, follows a logic all its own. One example: an SOE client of ours bought and owns a quite large plot of suburban real estate outside Chengdu. Its main factory buildings are set on top of it. The land is booked at its purchase price as an intangible asset on the company balance sheet. Under Chinese BAAP, this is apparently allowed.

To meet SASAC-imposed growth targets, SOEs are known to boost revenues through a kind of wash-trading. Profit isn’t impacted. Only top-line. BAAP turns a blind eye.

Every SOE is audited once-a-year. Few private companies are. The main purpose of the audit is not only, as under GAAP, to determine accurately a company’s expenses and revenues. It’s also to make sure all of last year’s assets, plus any new ones bought during the current audit year,  can be located and their value tabulated.

From the standpoint of a potential investor, while the logic of Chinese BAAP may take some getting used to,  an SOEs books can be understood and, for the most part, trusted. There should be little worry, as in private sector companies, that there are three sets of books, that sales are being made without receipts to escape tax, and that company cash flows through an ever-changing variety of personal bank accounts. SOE management, in my view, wouldn’t know how to perpetrate accounting fraud if they were being paid to do so. They’ve grown up in a system where everything is counted, entered into the ledger, and outputted in the annual SASAC audit.

An investor who takes majority control of an SOE, as in the two deals we are now working on,  would want to transition the company to using more standard accounting rules. It would also want the company to avail itself, as few seem now to do, on all legal methods to defer or lower taxes. In short, there is good money to be made in China going from BAAP to GAAP.

 

China SOE Buyouts — Case Study Part 2

August 7th, 2013 No comments

Jin finial

When you can find them, State-Owned Enterprise (“SEO”)  buyouts are among the better investments in China. The reasons: the companies are cheap, professionally-managed and free of accounting fraud. The not-trivial challenge: finding good SOEs that can be bought.

For such an important part of the world’s second-largest economy, Chinese SOEs are widely misunderstood. They account for at least 20% of China’s GPD. Some estimates put SOEs’ contribution to GPD at 60% or higher. But, SOEs are often characterized, to quote from a World Bank analysis, as “dying dinosaurs that continuously absorb resources from the economy but produce little economic value.”

To be sure, there are many SOEs that fit this description. But, equally, there are plenty of good businesses among China’s more than 150,000 SOEs. The good ones, quite often, can be made substantially better by bringing in outside capital and chopping away at the heavy bureaucratic crust.

Buyouts make money when a new owner buys an business for less than it’s worth, then reinvigorates it. Generally that’s done by buying lazily-run subsidiaries inside larger conglomerates.

No conglomerate anywhere, at any time,  has been more laid-back about managing its assets than SASAC, the huge government organization that is the legal owner of most Chinese SOEs.

SOEs operate in, but are not entirely of, the market economy. They benefit from cheap and plentiful capital via loans from state-owned banks. But, SASAC is generally far more concerned with increasing revenues and investment than profits. SASAC generally doesn’t demand SOEs pay it dividends. Instead, it asks for an audit every year that shows an SOE’s revenues and assets are growing, and no money is actually being lost or assets pilfered. SASAC doesn’t act like an owner so much as a custodian.

SASAC’s casual attitude to profit-making filters down to all levels within an SOE.  Given the choice to maximize or minimize profits, most SOEs will choose the latter.  The goal is to make a little more than last year, but not so much that SASAC, or more senior levels in government, begin to ask questions. With few exceptions (mainly larger centrally-administered SOEs quoted in the US like China Mobile and PetroChina) the corporate equivalent of a “gentleman’s C“, a net margin of around 2.5%, is considered satisfactory.

You don’t need to be a Buffett, Bonderman, Kravis, or Rubenstein to make money buying the right Chinese SOE. You generally don’t need to get your hands too dirty, launch a hostile takeover, borrow a ton of money, or make yourself unpopular by firing surplus workers. It’s going to be enough in most cases just to retain and incentivize current managers, and inform them that their goal now is to deliver net margins as good as, if not better, than private sector competitors.

Not in all cases but many, the current management of an SOE is quite good, professional, dedicated. The managers operate within a system that downplays the importance of maximizing profit. So, they behave correspondingly. But, that doesn’t mean they don’t know how to do so, especially when they have their salary or share options tied to profitability.

In a previous post I mentioned our two new SOE clients. We are working now to privatize them by selling majority ownership to a private sector investor. Both are 100%-owned by one state-owned holding company which, in turn, is fully-owned by another, even larger SOE holding group. Above them, is the local SASAC in the city where the holding companies are both headquartered. No sooner did we start asking the managers how to improve profits, then they began to share information on how much additional profit was being left unclaimed — unnecessary commission payments, tax rebates not filed for, revenues booked through unrelated group companies.

In the case of these two companies, the current CEOs have been running the businesses since they were started more than five years ago. They are about as far from a stereotyped paper-pushing “SOE Manager” as one could imagine. They are in their mid-40s, and take evident pride in running their businesses as efficiently as any Western manager would. The difference is, a lot of the profit they earn is siphoned off through lots of internal layers within the holding group. At the moment, that’s of little concern to them. They are ordinary salaried workers giving SASAC precisely what it wants. Giving more would do nothing to advance their careers, or fatten their pay packets.

These two CEOs are excited and ambitious to run independent private sector companies that will be free to make and keep as much money as the market and tax laws allow. I have confidence that in both cases, net income would more than double within two years, and triple within five.

What’s needed isn’t restructuring. It’s gardening. You weed out all the unnecessary fees, commissions and chop back the overheads. This reveals the companies’ genuine – and impressive – bottom line.

We are still doing our internal work with the companies, but will soon start the search for new majority owners for each company. All the layers above, up to and including the local SASAC, seem to support these transactions. Why? The holding company already has one very successful publicly-traded company. Once spun off, these two subsidiaries should follow a similar path and one day go public. That is the surest way to assure the companies have sufficient access to low-cost capital and so finance continued growth. Both companies, with revenues of over $100mn, are growing quickly.

Everyone is currently in agreement that the best way for these two subsidiaries to become not just the largest but the most profitable companies in their industry in China is by bringing in majority private shareholders, both to invest in the business and provide more focused, profit-oriented ownership. They sought our investment banking and advisory help to do so.

This isn’t to say these deals, or any SOE takeover, is as effortless as body-surfing. The privatization process in China is still evolving. Any transaction like this will likely generate some opposition. From whom? And from what level? Both are impossible to say.

A separate concern of mine: there are far too few capable and experience takeover firms active in China. Among those that are around, the level of experience and comfort with buying control of an SOE is not uniformly high. Done right, the new owners would be able to profit from a large gap between the current asset value as calculated using SASAC rules and each company’s level of underlying and future profitability. In other words, you buy using NAV but sell later on a p/e multiple.

Making money on that swap, from NAV-to-p/e, is the simple idea at the heart of many of the world’s most successful takeovers. Opportunities to do this are now quite rare in the US and Europe, which is one reason the returns for big buyout firms like KKR, Blackstone and Carlyle has generally been trending down over the last 25 years, and why it’s harder for Warren Buffett to find the kind of underpriced gems he treasures most.

The best days of takeovers have passed, right? Or should Buffett, Rubenstein, Bonderman and Kravis be booking flights to China?

 

 

Preying on China’s distress — IFR Asia

August 4th, 2013 No comments

IFR

Preying on China’s distress

IFR Asia 806 – July 27, 2013 | By Timothy Sifert

Global advisory firms are beginning to allocate more resources to China in a bet that slowing economic growth and tighter credit conditions will lead to a rise in restructuring opportunities.

Slowing growth and mounting debt burdens are creating an environment that is, in theory, ripe for turnaround specialists and distressed debt investors. A number have been adding senior staff in China, a market that remains largely untapped relative to the rest of Asia.

Investors, however, warn that restructuring specialists may find doing business in China a lot more difficult than they anticipated.

AlixPartners has doubled the size of its team in Asia to about 70 in the last two years. Alvarez & Marsal appointed Yansong Xue and Bing Liu as directors in Beijing this month. Both firms plan to continue expanding in China and elsewhere in Asia.

“Most of our work is done when you have a leveraged Chinese company with some kind of private-equity firm backing it and it’s in default,” said Ivo Naumann, managing director, AlixPartners, Shanghai. “We are engaged by equity owners and creditors to help with leadership in the process, and are often brought in as an interim manager.”

Turnaround shops, however, are also targeting the underperforming China operations of multinational corporations.

“For many Western companies, five or 10 years ago, you just had to be in China irrespective of profitability, and that was fine when you were making a lot of money in Europe and the US, but it’s not working now,” Naumann said.

Chinese growth has slowed in nine of the past 10 quarters, and data last week showed that the country’s production lost momentum for the third straight month.

At the same time, companies are facing a tougher time accessing financing as regulators force banks to reform their risk management and rein in off-balance-sheet lending. A liquidity squeeze in China’s money markets has pushed up the cost of bonds, and no domestic IPO has priced since October 2012.

Refinancing pressures in China have rarely led to the kind of restructuring or turnaround opportunities that are common in the US and Europe. No domestic bond issue has defaulted, while local politics and laws related to restructuring have often frustrated international investors, adding to general linguistic and cultural differences.

Advisers, however, believe the renewed focus on reform under Premier Li Keqiang will lead to more opportunities for conventional workouts.

Predator and saviour

Many on China’s long list of PE-backed companies are already feeling the pressure, they say.

Over the past decade, the market for Chinese PE has grown rapidly, only to decrease just as rapidly as the local PE markets offered few exit opportunities. PE investments in China are on pace to reach US$6.4bn for the full year 2013 – that is a 64.2% decline from the 2011 peak. (See Chart.)

This ebb in new investments means fund managers are spending more time on existing portfolios.

“[R]unning a private equity fund has become much more of a value-add business in that funds now have to manage their portfolio companies,” said Oliver Stratton, co-head of Alvarez & Marsal Asia, a turnaround firm. “They’re not only investors, and they can’t be passive. So, they’re thinking, ‘we actually have to grow earnings now and fix up the balance sheet’.”

What is more, foreign firms have not always committed the necessary local resources – or had the patience – to address the full scope of the market. The effect is a missed business opportunity.

“Broadly speaking, there is an almost-unimaginably huge money-making opportunity available for turnaround/restructuring firms to act as predator and saviour for PE portfolios in China,” said Peter Fuhrman, chairman and CEO of China First Capital, an international investment bank focusing on China.

“But – and it’s a very big but – there really are few if any firms with that capability, experience, focus. It is, therefore, a great example of why often the best and easiest opportunities to make money in China are overlooked or not acted upon.”

Meanwhile, in part because China’s bank loan market is opaque, potential investors have had to go to greater lengths to get basic information on local assets. On a few occasions, investors have called on risk consultancies to vet PRC loans and the parties backing them.

“We don’t help clients source investments, but we see growing demand to investigate non-performing loans in China,” said Tadashi Kageyama, senior managing director at Kroll Advisory Solutions in Hong Kong. “Interest in these assets should grow after the liquidity squeeze this year.”

Out of court

The Chinese court system, and the way it deals with bankruptcy, can be both a benefit and a hurdle to restructurings. Turnaround specialists said that judges were often quick to liquidate a defaulted firm, rather than engage in a lengthier workout process that could have benefits for debtors and creditors.

“China has a modern bankruptcy code that’s fine and as good as in Europe,” said AlixPartners’ Naumann. “It’s just that the courts and creditors have limited experience in executing it. Their intentions are good, but, in mainland China, a judge’s performance is often measured by the number of cases decided. So, for a judge to engage in a lengthy and highly complex turnaround process, it is challenging. This may sometimes lead to a situation where a liquidation is given priority over a turnaround process.”

As a result, sources said, PE-backed companies – their managers, debtors and creditors – often wanted to settle things out of court. That is where restructuring firms can come in to turn things around.

Yet, to be a relative success in this market is probably going to take a bigger commitment than firms have demonstrated in the recent past. Not a lot of money has been made in China restructuring relative to the rest of the world, sources say.

“It is not particularly difficult for foreign or domestic firms to make money in China, but why no turnaround firms? It starts from simple, humble, unsexy things like none of these guys have real offices in China with significant Chinese-speaking teams with experience in fixing what’s broken inside a Chinese company,” CFC’s Fuhrman said. “They will quickly gravitate to better-paying jobs in PE or investment banking.

“Without teams, you can’t do squat.”

 

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