Just about everyone has experienced a miraculous coincidence at least once in their lifetime, a chance encounter with a friend at a place and time where neither side would ever have expected to meet. I’ve had a few in my life. The most memorable was running into Giovanna, an old girlfriend of mine from when I was a graduate student at the Chinese University of Hong Kong. I literally bumped into her, eight years after losing touch (this was in the pre-email era) one morning at the bustlingly gorgeous Campo de’ Fiori vegetable market in the center of Rome.

We quickly got reacquainted, and she juggled me and her then-current boyfriend for awhile. I was a foreign correspondent for Forbes based in London. She was living in Rome, close to the market, one of my favorite spots in one of my favorite and most-visited cities in the world.

There was a high degree of improbability about that meeting in Rome. But, it wasn’t completely unfathomable, since she was an Italian, and even when I knew her, interested in film-making. Rome is the center of that industry in Italy. Giovanna had studied in China, spoke good Chinese and had landed a small job helping Bernardo Bertolucci shoot scenes in China for “The Last Emperor”.  She parlayed that into a friendship with the director and the producer of Last Emperor, and then found other work in the film business.

In Chengdu recently, I had an even more remarkable coincidental meeting than that one in Campo de’ Fiori. At a large and fancy restaurant there, a friend of mine from work, Nick Shao, who is a Managing Director of PE firm Carlyle in Shanghai, came up and greeted me as I sat down at a table with two people I only just met.

My brain circuitry is not what it used to be. It probably took me two to three seconds to actually figure out who Nick was and how I knew him. Then it clicked, of course, and I started burbling in my bad Chinese about how remarkable the whole thing was – why was he there? Doing what? Was the food any good?

Running into Nick was remarkable for a lot of reasons, including the fact I know a comparatively small number of people in China, had not been in Chengdu in 28 years, and was in a restaurant that seats at least 800 people. To end up at a table nearby to someone I knew, in a city of 11 million that neither of us have any connection to, in a country with the largest population in the world, that’s a level of unlikelihood that I can’t even begin to quantify. I’d be hard-pressed to find one of my own family members in that restaurant, it’s that large and crowded.

As I found out, Nick was in Chengdu for an EMBA course he’s taking. This also left me a little nonplussed, since I knew Nick already had an MBA from Columbia. Why would anyone need two? Why was his Shanghai university convening its class at a not-especially famous restaurant in Chengdu? I still don’t have solid answers to either of these questions, even after exchanging emails with Nick later that day.

For my part, I was in Chengdu to participate in a PE conference organized by the Sichuan government. I skipped the official lunch to meet some friends-of-friends. It would not be stretching things to say the last place I’d expect to meet someone I know would be that restaurant, in that city, in that country, at that date and time.

I had a great three days in Chengdu,  eating, chatting and walking around China’s most relaxed, pleasant and livable major city. Meeting Nick made it very much more memorable, just as I continue to remember, when I think of Rome, that meeting, over 20 years ago, in Campo de’ Fiori.

For me, at least, this coincidental meeting spurred a lot of what little I can muster in terms of philosophical reflection. It’s all hackneyed stuff, of course, but our lives really are created by the miracle of birth, and punctuated thereafter by occasional miracles, large and small. The world is, in its most benign state, the motive force for the coming true of every sort of wonderful, unexpected but thoroughly delightful possibility. Dreams come true. Happy coincidences occur.

One way or another, every good money-making idea ends up in China. But, they don’t all succeed. Possible case in point: current efforts by China’s Citic Capital Partners to create a homegrown competitor to the global private equity leaders Blackstone, TPG, KKR, Carlyle. 

These global firms started and prospered in the US at very opportune time, when many tired, poorly-managed older industrial companies were in need of shaking up.  The PE firms seized this opportunity. Though their styles and investment appetite differed somewhat, all had a similar M.O: buy a controlling stake in an existing business (or division of a larger corporation) using a slim wedge of their own equity capital and a large helpings of debt, either in the form of bank loans or bonds. They then installed new management, slimmed down bloated workforces,  tightened operations, improved cash flow and margins to pay down the bank debt, and then exited by selling the newly-fit company to someone else, or staging an IPO. 

Today’s global PE giants were all once known as Leveraged Buyout shops. The firms ditched that name in favor of the more innocent-sounding term of Private Equity about ten years ago. But, it’s the leverage that gave the global firms the keys to the kingdom, and often produced stunningly high return on equity. The math is simple. If you only put up 25% or so in cash, and then double the value of a business by improving profitability, you can earn upwards of six to eight times your original equity investment. Returns like this, and often higher, allowed the big global firms to raise well over $100 billion in the last five years, and made their founders billionaires. 

When the financial crisis struck in the summer of 2008, banks stopped supplying the debt finance. No leverage, no buyouts. The last major deal, Cerberus’s $7bn purchase of 80% of Chrysler from Daimler-Benz collapsed in 2007, with losses of over $5 billion. The big firms are still licking their wounds. The dearth of bank finance means the deals they are trying to do now require them to put up all or most of the cash themselves, without recourse to leverage. That, of course,  will put strong downward pressure on what were once very high rates of return. 

With what looks to be bad timing, a successful and well-established Chinese PE firm has now apparently decided to try to become a leader in doing buyouts in China. At first glance, leveraged buyouts look well-suited to China. There are lots of tired old industrial companies, mainly state-owned enterprises (SOEs),  that seemingly could benefit from some radical restructuring. Slice the fat away and a trimmer, profitable business could emerge. 

There are, however, a number of serious problems with this business model in China. Start with the fact that it’s generally difficult, if not impossible, to buy a controlling stake in one of these giant SOEs. If you don’t have control, you don’t have a sure way to implement any changes to improve things. Next, leverage is also unavailable to finance such deals. Third, for the most part, all the better SOEs have already gone public, leaving a rump of outcasts that no amount of restructuring could save. Fourth, arranging an exit is at best uncertain and time-consuming, and at worst, impossible, depending on the decision of China’s security regulators. 

Finally, any Chinese firm entering the buyout market now will need to compete successfully against TPG, Carlyle, Goldman Sachs, KKR and Blackstone, all of whom have long experience in the field as well as established operations in China. They are struggling to find good buyout deals in China. Too much talent and money is already chasing too few opportunities to do big buyouts in China. 

There have been a few success stories doing buyouts in China. The most notable was TPG’s purchase five years ago for Rmb 1 billion ($145 million) of 16.76% of Shenzhen Development Bank. TPG was able to exercise significant management control. They brought in an American CEO, improved the bank’s operations, and are now in the process of selling it to Pingan for over Rmb 11 billion ($1.7 billion). If the deal is approved by Chinese regulators, TPG stands to make a profit of about $1 billion, or an eleven-fold return. 

The lure of those fat returns – and probably the reputational boost that comes with pulling such deals off –  have seemingly convinced Citic Capital to focus on buyouts in China. Citic Capital launched this new strategy over a year ago, and closed its second dedicated China buyout fund, raising over $900mn,  in February of this year. Overall, Citic Capital has over $3bn under management. 

I’ve met some of the Citic Capital team, and they are all first-rate: smart and clearly able. Still, the shift in investment focus seems puzzling, at least to this outsider. 

Citic Capital Partners is the PE arm of one of China’s best banks, and a leader in providing loans to private SME. CITIC Bank could certainly continue to provide a steady source of high-quality deal flow to its PE business.  Indeed,  Citic Capital was successful and well-established doing the best kind of PE deals in China: investing $10 million – $20 million per deal to acquire a minority stake of around 20% in a fast-growing private Chinese company, then aiding that company in the process of planning for and executing a successful IPO.  

Why would Citic Capital change a winning formula? My sense is that it’s part of an effort by Citic Bank to differentiate its PE business, and establish early leadership in an area that they believe may well day prove lucrative. This may turn out to be prescient. China’s laws change often, and somewhat unpredictably – just because buyout investments are difficult today, does not mean they will always be.   

But, the problem remains that good buyout deals in China are scarce, and competitors are numerous. Buyouts are out of favor everywhere in the world, including with those who put up the money, the endowments, pension funds, family offices and other institutional investors who serve as Limited Partners. 

At this moment in financial history, and likely for quite a long while to come, the best risk-adjusted returns are available for minority PE investments in successful fast-growing Chinese SME. That’s where Citic Capital and other firms have made their reputation and made investors very good money. 

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.

Blackstone, the giant American PE firm, is now trying to raise its first renminbi fund. Its stated goal is to provide growth capital for China’s fast-growing companies. Blackstone isn’t the only international private equity firm seeking to raise renminbi to invest in China.  In fact, many of the world’s largest private equity firms, including those already investing in China using dollars, are looking to tap domestic Chinese sources for investment capital.

Dollar-based investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult, often impossible, and deals take longer to close than competing investors with access to renminbi.

Blackstone enjoys a big leg up in China over other international private equity firms looking to raise renminbi. Its largest institutional shareholder is China’s sovereign wealth fund, CIC. Knowing how to get Chinese investors to open their wallets is a skill both highly rare and highly advantageous in today’s global private equity industry.  

There are two reasons for this stampede to raise renminbi. First, more and more of the best investment opportunities in China are SME with purely domestic structure – meaning they cannot easily raise equity in any other currency except renminbi. The second reason is the most basic of all in the financial industry: if you want money, you go where there’s the most to spare. Right now, that means looking in China.   

In theory, the big international private equity companies have a lot to offer Chinese investors – principally, very long track records of successful deal-making that richly rewarded their earlier investors.

The international PE firms have more experience picking companies and exiting from them with fat gains. They also do a good job, in general, of keeping their investors informed about what they’re doing, and acting as prudent fiduciaries. 

So far so good. But, there’s one enormous problem here, one that Blackstone and others presumably don’t like talking about to prospective Chinese investors. Their main way of making money in the past is now both broken, and wholly unsuited to China. They’re trying to sell a beautiful left-hand drive Rolls-Royce to people who drive on the right. 

Blackstone, Carlyle, KKR, Cerberus and most of the other largest global private equity companies grew large, rich and powerful by buying controlling stakes in companies, using mainly money borrowed from banks. They then would improve the operating performance over several years, and make their real money by either selling the company in an M&A deal or listing it on the stock market.

The leverage (in the form of the bank borrowing) was key to their financial success. Like buying a house, the trick was to put a little money down, borrow the rest, and then pocket most of any increase in the value of the asset. 

It can be a great way to make money, as long as banks are happy to lend. They no longer are. As a result, these kinds of private equity deals – which really ought to be called by their original name of “leveraged buyouts”, have all but vanished from the financial landscape.  It was always a rickety structure, reliant as much on access to cheap bank debt as on a talent for spotting great, undervalued businesses. If proof were needed, just look at Cerberus’s disastrous takeover of Chrysler last year, which will result in likely losses for Cerberus of over $5 billion. 

In his annual letter to shareholders this year, Warren Buffett highlighted the inherent weaknesses in this form of private equity: “A purchase of a business by these [private equity] firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.” 

On their backs at home, it’s no wonder Blackstone, Carlyle, KKR are looking to expand in China, All have a presence in China, having invested in some larger deals involving mainly State-Owned Enterprises. But, to really flourish in China, these PE firms will need to hone a different set of skills: choosing solid companies, investing their own capital for a minority position, and then waiting patiently for an exit. 

There’s no legal way to use the formula that worked so well for so long in the US. In China, highly-leveraged transactions are prohibited. PE firms also, in most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China. 

I have little doubt Blackstone, KKR, Carlyle can all succeed doing these smaller, unleveraged deals in China. After all, they employ some of the smartest people on the planet. But, these firms all still have a serious preference for doing larger deals, investing at least $50mn. This is also true in China.

There are few good deals on this scale around. Very few private companies have the level of annual profits (at least $15mn) to absorb that amount of capital for a minority stake. Private companies that large have likely already had an IPO or are well along in the planning process. As for large SOEs, the good ones are mostly already public, and those that remain are often sick beyond the point of cure. In these cases, private equity investors find it tough to push through an effective restructuring plan because they don’t control a majority on the board seats. 

Result: some of the companies best-positioned to raise renminbi funds, including Blackstone, have an investment model that seems ill-suited to Chinese conditions. They may well succeed in raising money, but then what? They’ll either need to learn to do smaller deals (of $10mn-$20mn) or bear the heavy risk of making investments in the few larger deals around in China.  

Any prospective Chinese LP should be asking Blackstone and the other large global private equity firms some very searching questions about their investment models for China. True, these firms all have excellent track records, by and large. But, that past performance, based on the leveraged buyouts that went well, is of scant consequence in today’s China. What matters most is an eye for spotting great entrepreneurs, in fast-growing industries, and then offering them both capital and the knowledge that comes from building value as investors in earlier deals. 

Prediction: raising huge wads of cash in China will turn out to be easier for Blackstone and other large global PE firms than putting it to work where it will do the most good and earn the highest returns.

I never much liked the term “Private Equity” since it serves two very different meanings and even more different business models. That difference has never been more stark than it is today. There is what I like to call “Big PE” and “Small PE”. One is hurting, and the other is still thriving. Luckily for China First Capital, we focus working with the part of the PE industry that’s still in good shape.  

In Big PE, large-scale, multi-billion-dollar deals are done by famous firms of the likes of Kohlberg Kravis Roberts, Blackstone and Carlyle. In Small PE , another group of PE firms thrive by finding great companies, at an earlier stage in their development, and backing them with growth capital. 

Big PE targets larger, often publicly-traded companies, or divisions of these larger firms. Using a slug of equity to support a large pile of bank debt, these private equity deals are based on acquiring a controlling interest in a company, and can deliver outstanding results by tossing out tired and underperforming management teams, tightening up on operating efficiencies, investing for growth. In 1-3 years, if things go well, the Big PE firm exits the now-improved business through either a trade sale or primary stock market listing. 

What matters most here essentially is finding a poorly-run business, with a bad capital structure and often worse management. (To take one recent example among many, think of Cerberus’s purchase of Chrysler’s from Daimler.) Ideally, a Big PE firm can turn things around quickly after buying control, and get an exit where the debt is paid off, and the underlying equity gets a very high rates of return. 

There are two big problems now in Big PE: the drying up of credit, and the shrinking valuations put on the businesses spiffed up for sale by the PE firms.  The recession compounds the problems, since the deals are built on leverage, and the bank debt will often have aggressive covenants attached to it. Those covenants (generally targeting  operating metrics like increasing EBITDA) are much harder to achieve in a down economy. Covenants get breached, deals need to be restructured with the Big PE firm pouring in more of its own capital, and the time and value of an exit go in the wrong directions: it takes longer to make less. 

Not a good business to be in at the moment. 

Then there’s Small PE, which has never looked sounder. The core skill-set here never goes out of fashion. It’s the ability to find a great company with the potential to grow far larger. Small PE firms invest their own money, for a minority stake in a business. They then provide what help they can to management, and if they’ve chosen their portfolio investments well, will wait confidently for the optimal moment to achieve a very solid return on each individual investment.  

In other words, Small PE is not built on complex financial engineering, but on good, old-fashioned “stock-picking”. 

Last month, David Rubenstein, the co-founder and managing director of Carlyle Group, one of the biggest of the Big PE,  gave a presentation in Tokyo titled “What Happened? What Will Happen? A Look At The Changing Investment And Private Equity Worlds” . Rubenstein, who has made over a billion dollars personally in the PE industry, tried to summarize all the tectonic forces destabilizing Big PE. There’s a lot of alarming stuff in his presentation. The key line: “The Credit Crisis Has Dislocated the Private Equity Industry “. (If anyone would like a copy of the Rubenstein presentation, email me at peter@chinafirstcapital.com)                                                                                                                                          

Rubenstein’s prediction, which I share: “Deals: Smaller, Less Frequent, More Overseas”. In particular, Rubenstein foresees more PE firms raising money to invest in Asia. The fact he cites: Asia private equity fundraising has increased but remains small at 9.2% of the $331 billion raised by U.S. PE funds in 2007 considering that the combined GDP of the above countries is 93% of the GDP of the U.S. 

No question, Big PE will now try to act more like Small PE. The problem they’ll face is that they’re not well structured to find, assess and invest in smaller-sized deals. My guess is that the good PE firms already operating in Asia – the ones we work with regularly at China First Capital – will  be able move quicker and smarter than their new Big PE rivals. Here I means firms like China Renaissance Capital, (www.crcicapital.com) which has a great record of finding strong middle-market companies in China, investing wisely and at fair valuations, and then working alongside management to create the operating conditions for an ideal exit. 

Rubenstein’s talk included a table showing the 2008 year-to-date performance of a number of the most well-known Big PE.  All the following have lost money this year. What you see here is a cumulative loss of many tens of billions of dollars:

􀂃 Tosca Fund – 62%

􀂃 Templeton Emerging – 50%

􀂃 Kensington/Citadel  –37%

􀂃 Satellite Overseas  -30%

􀂃 Marathon Global Equity – 20%

􀂃 Canyon Value Realiz. –20%

􀂃 Goldman Sachs Investment Partners –16%

􀂃 Deephaven Global –15%

􀂃 Millenium Global HY –14%

􀂃 Cantillon Europe –13%

􀂃 Zweig-Dimenna Intl. –8%

􀂃 Harbinger Offshore -5%

􀂃 Cerberus Intl. –3%

􀂃 Viking Global Equities –2%

The good Small PE firms are having far better years. My own prediction is that this performance gap will only widen over the next two years, as the deal pipelines for Asian PE firms we work with remain very strong. Big PE has to re-learn their approach, and try to master a new set of skills. All the while, they’ll be losing out on many of the best opportunities in Asia to their smaller, more nimble and more experienced rivals. 

It’s hard to find a dancing elephant. The reason: it’s hard to teach the elephant the steps.