China Private Equity

“Five years ago, all I had to worry about was producing enough to earn a small profit. Now I spend time dealing with employment issues, environmental regulations, tax policies, trying to increase market share and staying ahead of competitors. The pressure is much worse. ”

Welcome to the suddenly changed and increasingly pressured world of Chinese corporate management. 

This comment comes from the boss of a large, integrated chemical factory in Shandong. He and I were talking recently. He is still a relatively young guy of around 40. But, in his 15 year career as first an engineer, then a manager and finally as factory boss, he has seen the purpose, methods, scope, goals and responsibilities of Chinese management change from top to bottom. 

Like much else in China, company management has undergone a lifetime’s worth of change in a matter of a few years. It’s a byproduct of larger forces at work in China’s economy – the withdrawal of direct state planning and control, the ascendancy of the private sector, China’s entry to the WTO and the opening of China’s markets to imports, the rise of a vibrant consumer market. All of these have made planning and decision-making far more intricate and the stakes far higher for Chinese corporate managers, both in state-owned and private companies. 

In the case of my friend in Shandong, he is working for a company majority owned by the state. In theory, that should make his management tasks far easier. In most cases, the Chinese government – whether at national, provincial or local level – is a very lenient shareholder. In fact, they would appear to the ideal owner for any manager who is looking for easy ride. 

In China as elsewhere, when the state is the owner, no one is really in charge. The Chinese government is not looking for dividends. Most profits stay inside the company.  

Here’s the paradox that Chinese managers all live with: as undemanding as the Chinese government is as a shareholder, they are increasingly demanding as a regulator and law-maker. That is a big reason why corporate management has gotten so much more complex in China. In a short space of time, China has gone from a more laissez-faire stance to one with strict environmental, tax and labor laws that rival those of the US and Western Europe. 

True, these tougher regulations are not yet universally applied or enforced. But, any Chinese manager who chooses to act in total disregard of these rules will eventually find himself in deep, deep trouble. Take labor laws. China continues to introduce new forms of workplace protection that give important new rights to hired staff and restrict the prerogatives of management. Any Chinese with a complaint over pay or conditions can complain directly to the Laodong Ju, or Labor Bureau, a quasi-state body that enforces labor laws. 

The process is not without its hiccups. Management can still intimidate and threaten workers who seek redress. But, the system does work. 

Example: a friend of mine worked for several years as a salesperson for an electronics company based in Shenzhen. She was paid part in commission. She did her job well. For months, then years, the boss held back the commission payments, claiming cash flow problems. This is old style China management: don’t pay, offer excuses. This boss assumed he could continue indefinitely with this trickery, in part because the general view is that female workers in China are more easily cowed or mollified. 

Instead, my friend quit without warning,  went right to the Labor Bureau, which made one call to her ex-boss. No investigation. Just a phone call and a stern warning from the Labor Bureau. My friend got her money – about $20,000 in total – within a week. The boss will now have a much harder time doing what he’s always done – pad his own take-home by cheating workers out of what they are entitled to. Tyrannizing workers is no longer a workable HR strategy for a Chinese management team. 

New environmental rules are, if anything,  even more disruptive of old lax ways of managing business in China. Managers who choose to improve margins by ignoring pollution standards are risking an early unpaid retirement. Example: a client of ours is the leading environmentally-friendly paper manufacturer in Shandong. Two years ago, he had 29 competitors in Shandong. Today, he has only three. 

The other 26 were shut down, virtually overnight, for violating environmental standards. The managers at those factories, most of which were around for many years, now likely understand better than most how much the craft of management has changed in China.  

Elsewhere in Shandong, my friend the chemical company boss, is now making another decision that was unimaginable when he began his career: he is working on a plan for a management buyout of the factory. The business is now 65%-owned by a large local coal mine, which in turn, is owned by the provincial government. 

The buy-out plan is still in its early stages. To succeed, he’ll need to persuade several levels of government – no one is quite sure how many – and also take over some significant liabilities, including debts of about $15mn.  It’s not clear if the current management will need to put up cash to buy the government’s controlling stake, or if, as preferred, they can pay in installments, using cash from the business. 

Servicing debt and having most of one’s wealth tied up in illiquid shares of one’s company are other adaptations now being learned by Chinese management. Each year, their working lives grow harder, more pressured and, for the more talented and nimble ones, far more financially rewarding.  Stride-for-stride with the modernization of China’s economy, Chinese corporate managers have gotten better faster than anywhere else, ever.

Congratulations to Kleiner Perkins Caufield & Byers on the successful NASDAQ IPO of its portfolio company AutoNavi, a Chinese mapping company that supplies maps for GPS navigation systems. KP owned 4.3% of the company prior to its recent IPO. At time of IPO, Kleiner owned 6,527,520 ordinary shares of AutoNavi, now worth around $25mn. That equates to a 2.5X rate of return over the four years KP held the investment.

The AutoNavi investment was made by KP’s main office in California, not Kleiner Perkins China, which was set up in 2007 to lead the US firm’s investing activities in China, and is still waiting for its first exit. According to KP China’s website , the AutoNavi investment is managed by KP China.

Two other venture capital firms also held AutoNavi shares at the time of IP, Walden International and Sequoia.

No firm in the venture capital industry can match the reputation, global influence and swagger of Kleiner Perkins Caufield & Byers (“KP”). KP is accustomed to outsized success and glory  – which makes the lackluster performance of KP’s China operation all the more baffling. For all its Midas-touch reputation in Silicon Valley, KP’s China operation looks more like 100% pyrite. It seems beset by some poor investment choices, setbacks and even rancor among its partners and team. The firm’s Chinese-language website even manages to misspell the Kleiner Perkins name. (See below.)

Two years ago, Joe Zhou, one of the founding managing partners of KP in China left the firm to set up a rival VC shop, Keytone Ventures. Two other KP partners in China have also left. Losing so many of its partners in such a short time is an unprecedented occurrence at KP — even more so that two of these partners left KP to set up rival VC firms in China.

A partnership at KP is considered among the ultimate achievements in the business world. Al Gore took up a partnership at KP in 2007, after serving as Vice President for eight years and then losing the presidential election in 2000. Colin Powell also later joined the firm, as a “Strategic Limited Partner”.

Joe Zhou left KP just 13 months after joining. When he left, he also took some of the senior KP staff in China with him. Zhou also negotiated to buy out the portfolio of China investments he and his team had overseen at KP China. They paid cost, according to someone directly involved in the transaction. In other words, KP sold its positions in these investments at a 0% gain. Factor in the cost of that capital, and the portfolio was offloaded at a loss.

This isn’t going to endear KP to the Limited Partners whose money it invests.  It also signals how little confidence KP had in the future value of these China investments the firm made. Other top VCs and PEs are earning compounded annual rates of return of +50% in China.

There was every reason to believe that KP would achieve great success when it opened in China in 2007. Indeed, when KP opened its China office, it issued a celebratory press release, titled “Kleiner Perkins Caufield & Byers Goes Global;Joe Zhou and Tina Ju to Launch KPCB China”.

Along with having the most respected brand in the VC industry, KP arguably has more accumulated and referenceable knowledge than any other VC firm on where to invest, how best to nurture young companies into global leaders. It’s roster of successful investments includes many of the most successful technology companies in history, including: Amazon, AOL, Sun, Genentech, Electronic Arts, Intuit, Macromedia and Google.

Opening in China was KP’s first major move outside the US – indeed, its first move outside its base in Silicon Valley. KP has only three offices in total, one in Menlo Park , California and one each in Shanghai and Beijing.  On its website, the firm’s China operations receive very prominent position. Two of the firm’s most renowned and respected partners, John Doerr and Ted Schlein, apparently played an active part in KP’s entry into China. Along with the high-level backing, KP also raised over $300mn in new capital especially for its China operations. One can assume KP has already taken over $15mn in management fees for itself out of that capital.

Beyond the capital and high-level backing, KP also prides itself on being better than all others in the VC world at building successful companies. So, it’s more than a little surprising that KP’s own business in China has so far failed to excel, failed even to make much of an imprint. Physician heal thyself?

I’m in no way privy to what’s going on at KP in China, and thus far have not had any direct dealings with them. I’ve always admired the firm, and fully expect the China operation to flourish eventually. For one thing, great entrepreneurs and good investment opportunities in China are just too numerous. A firm with KP’s deal flow, capital and experience should find abundant opportunities to make significant returns investing in IPO-bound businesses.

From the beginning, KP’s operation was  a kind of outsourced operation. Rather than sending over partners from KP in the US, the firm instead hired away from other firms partners at other China-based VCs. While this meant KP could ramp up in China more quickly, it also put the firm’s stellar reputation, as well as its capital, in the hands of people with no direct experience working at the firm.

The KP website lists 14 companies in the China portfolio. The portfolio is very heavily weighted towards biotech, cleantech and computer technology, mirroring KP’s focus in the US. Other tech—focused VCs in China have run into trouble, and are now shifting much of their investment activity towards established Chinese SME in more traditional industries. In the best cases, these SME have strong brands and very robust sales growth in China’s domestic market.

In my view, investing in these SME offers the best risk-adjusted return of any PE or VC investing in the world right now. KP has yet to make the shift. I wish KP nothing but success, and hope for opportunities in the future to work with them. Its technology bets in China may pay off big-time, in due course. But, meantime, KP is in the very unaccustomed position of laggard, rather than leader, here in China.

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It’s surely embarrassing, if not emblematic, that the home page of the Chinese-language version of KP’s own website manages to misspell the company’s name.  Check out the top-most bar on the page, where the firm is named “Kliener,  Perkins, Caufield and Buyers” .

Update: as of May 11, 2010, the Chinese version of Kleiner Perkins’ home page has been corrected.

Despite delays and continuing uncertainty, 2009 should see the opening of China’s first stock market for smaller, high-growth technology companies. Modeled on the NASDAQ in the US and AIM in London, this new market will be headquartered in Shenzhen, as part of the Shenzhen Stock Exchange, the smaller of the two stock markets in China.

Overall, this is a positive development for China’s financial industry, and the private equity and venture capital communities. Since China’s Prime Minister, Wen Jiabao announced in March 2008 the planned establishment of this new stock market, after almost a decade of internal discussion, the date for the launch has steadily slid back, a casualty of the 60% fall in China’s main stock markets this year.  

The final details have not been announced, but what seems clear at this point is that this new market will have significantly lower qualifying thresholds for companies seeking a stock market listing, compared to the main boards in Shenzhen and Shanghai. The numbers talked about are net assets above RMB 20 million (US$2.8mn) and revenues above RMB 10mn (US$1.5mn). There seems to be no requirement, as of now, for companies to be profitable at the time of listing. It’s possible, therefore, that companies listed on the new exchange will have market caps that barely exceed $10mn. 

Here’s my thinking. The largest quoted companies on the Shanghai market are trading at a price-earnings multiple of under 12. This is down, like the broader market, by almost 60% from recent highs. Put those kind of multiples on a small company with revenues under US$2mn and profits below $1mn, and you have the possibility of market caps in that very low range. True, high-tech companies tend to enjoy higher p/e multiples than more traditional large-caps. But, even so, this new stock market will be operating in some unchartered territory for China’s financial markets — companies with comparatively thin floats, low total market value, and so, most likely, higher price volatility. 

This could help explain why the Chinese government has repeatedly delayed plans to launch this stock market for high-growth companies. The regulators have probably seen this year all the volatility they care to see for a long time. 

Of course, the key factor won’t be earnings multiples or volatility, but the quality of the underlying high-tech businesses to be quoted on this exchange. Here’s where I see bigger problems. China, like its richer neighbors in Asia, as well as Western Europe, would very much like to rival the USA in nurturing successful high-tech companies in industries like software and chip technology. Across China, there are high-tech business parks where early-stage technology companies are concentrated. By one count, there are over 5,000 across the country. But, so far, there haven’t been many big break-out successes. 

The simple truth is that, as other countries have learned over the last decade, it’s hard to duplicate the particular success the US has in developing successful high-tech businesses. Having a stock market for high-tech companies is certainly not much of a factor. If so, Germany, which started its own high-tech company stock market, the NeuerMarkt ten years ago, would today be awash with leading technology firms. Instead, there are few, if any good tech companies in Germany and the Neuer Markt eventually was shut down. Britain’s AIM market has also failed to produce many successes in that country. 

In my mind, China does have a better shot than Germany, or Britain, or Japan. The main reason: Chinese are more entrepreneurial, and there’s more a culture of prudent risk-taking than elsewhere. If any country has a shot to achieve some of the same success the US has enjoyed building great technology companies, it’s got to be China. 

So, I hope this new stock market gets started early in 2009. It will provide more motivation – not that much is needed – to China’s budding technology leaders, and also provide another viable exit route for venture capital investors in China

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The PE industry in China is growing up. Fast. There are two key factors are at work. The first is the onrush of cash. The second is the onrush of talent.

Billions of new money is flowing into the Chinese PE industry. This is in marked contrast with the situation elsewhere. There’s not a lot of appetite for committing capital for any purpose except to invest in China. Other, traditional large PE markets (US and European buyout funds) are in cyclical decline, owing largely to the problems in global credit markets. Then, too, there’s the announced intention of the China’s $75 billion social security  fund to begin investing more freely in private equity firms in China.   

The weight of all this new money entering the China PE market is having an interesting effect on valuations. While valuations have certainly come down over the last year, they arguably would have fallen faster and farther if not for all the new money looking for opportunities. It’s what financial markets like to call “the weight of money” argument – the more cash there is around, the higher prices will rise. 

That’s one side effect of the new money entering the market. The other is that the level of professionalism, across the board, is rising in the PE industry. There’s a good reason for this. As the pool of capital grows, so too does the demand for higher levels of fiduciary responsibility and accountability. This is evident not just in tightening DD procedures, of course, but also in the involvement in the PE investment process in China of some the world’s leading professional service firms. 

This past week, I met with a Hong Kong-based partner at one of America’s largest and best law firms. This firm has been very active in China’s IPO market the last five years, and served as lead counsel for many of the larger public offerings by Chinese companies in US exchanges. This is a great business, with very fat fees. But, it’s also a highly cyclical one. The IPO market has cooled this year. So,  this firm has now made the shrewd decision to work on some smaller PE deals, rather than just the +$100mn IPOs they’ve relied on in the past.  The upfront transaction fees are, of course, lower. But, by getting involved earlier in a company’s financing process, at the time of PE financing, this law firm believes that it will be building a very solid base for the future. 

The calculation is very sound. By working on a PE financing today, the law firm will be ideally-positioned to serve as IPO counsel several years down the line. In other words, the firm is moving from being “transaction-based” to “relationship-based” , from targeting only high-dollar one-off IPO transactions, to building a longer-term relationship with a select number of very promising pre-IPO Chinese companies. Over time, this should yield far more revenue for the law firms that follow this path. There’s money to be made advising on PE investment rounds, on Board matters, on M&A work, and litigation. 

In principle, it’s an obvious shift to make, and more closely reflects best practices in the legal profession. In fact,  a good law firm, like a good merchant bank, should choose its clients wisely, and then commit to serving and advising them over the long-term. 

For us, at China First Capital, this is very much at the heart of our operating ethos. For larger law firms, it can sometimes be a tougher shift to make. For one thing, their existing fee structures make it harder to work with smaller clients.  The law firms will often need to cut fees as a way of building these longer-term relationships. That’s not always easy to do in a large law firm, where all partners are expected to generate maximum revenues. 

But, this change in mindset is happening. I know from experience, since this big US firm has offered to work with several of our clients, on their PE financings, and to cap their fees at an appropriate level. This is a great thing for our clients, since it gives them access to the best legal counsel possible, at a time when it will make a significant positive difference. The PE firms stand to benefit as well, since it should raise standards overall. 

This shift from transactional focus to relationship-building is more proof that China’s PE market is coming of age, and building the infrastructure on which to prosper for many decades to come. 

I’m just back in Shenzhen from a visit to a client in Kunshan, near Shanghai. For me personally, it was a particularly poignant trip. 

It’s the first time I’ve been back to Jiangsu since 1982, when I left Nanjing University. Thinking as much with my stomach as my head, I immediately on arriving at 9:30pm on Wednesday night cajoled Nina, my partner, to go on a late-night search of great Jiangsu food. I eventually lost count, but by the time I left, I must have had enough xiaolongbao to feed a nursery school.

 As thoroughly enjoyable as this “Jiangsu homecoming” was, it was not even close to being the highpoint of the trip. We spent two full-days with our client, in meetings with a very select number of Private Equity firms. The meetings, from my standpoint, were truly outstanding – a text-book example of how great businesses and a great institutional investors should interact.

In fact, our client and the PE investors were, to my eye, as well-matched as this pair of Tang Dynasty horses. 

As I told one of the PE partners afterward, I’ve been in a lot of initial meetings between companies and PE or VC firms. But, never was I involved in a investment meeting that was conducted at such a uniformly high level, with both company and investor executing at the highest level of accomplishment and professionalism. 

For the PEs, this was the second-round of meetings, following earlier ones in Shenzhen, with our client’s CFO, that focused primarily on the company’s financial performance. Our client’s core leadership and ownership, however, are both based in Kunshan. So, there was even more to discuss in this second round meeting. 

For our client, this was on-the-job training. They’ve built an enormously successful business, with sales this year in excess of $120 million, and a strong likelihood of becoming, within five years, a multi-billion dollar enterprise. But, the client has done all this without equity finance, using only retained earnings and bank debt. So,  they’d never before presented themselves to sophisticated and experienced equity investors.  They don’t come any more sophisticated and experienced that these particular PE investors, with track records, both as individuals and as firms, that put them at the top of their profession. 

Our client more than exceeded our highest expectations, preparing exhaustively and answering comprehensively. 

China First Capital works to find the right investor for its clients. Not the investor offering the highest valuation, or the quickest path to IPO. We give this a lot of thought, matching the strengths of our client to the strengths of a particular PE firm. Done right, it’s transformational for both company and investor: a case of the total value created not being just larger than the sum of the parts, but exponentially so. 

It’s early yet in the process. We’re planning on several more meetings with PE firms. But, I left Kunshan even more optimistic about our client’s future, building a great partnership with a PE investor. 

It may not sound like it, but it’s meant to be my highest compliment to both our client and the PE firms we met with this week:  the xiaolongbao were good. The meetings were better. 

One of the supreme satisfactions of my work – and I’m fortunate that my job offers quite a few – is the time spent advising laoban (“business owner” in Chinese) on the value of private equity investment. These owners are entrepreneurs, not financial engineers. So, the world of private equity deal-making and finance is often entirely unfamiliar. As I tell these laoban, in my less-than-fluent Chinese, “you have already done the hardest thing possible in business, by taking an idea, adding little or no capital, and created in China, the most competitive market in the world, a successful business of significant size and fantastic prospects.” Compared to this, anything will appear easy, including closing a round of equity capital from one of the leading private equity or venture capital firms. 

Now, of course, closing a PE investment round is anything but easy. It involves, at a minimum,  a sizable amount of time, stamina, senior-level attention, perseverance, transparency, thoroughness and commitment to building a fully-aligned partnership with an outside investor.  I’ve seen it from both sides, both as a CEO and as a venture capitalist. The process can seem like breaking rocks with a spoon. 

But, it’s always rewarding and inspiring for me to see how quickly our laoban start mastering the intricacies of raising capital. They climb the steep learning curve fast. But, it is still a learning curve, and I’ve often made the process harder by doing an inadequate job preparing them for their first meetings. In fact, there ought to be a typically wise four-character Chinese proverb, or chengyu, to describe it: “Good students. Poor instructor.” 

I’ll admit to being a poor instructor. But, an improvable one? I’d like to think so. 

Together with my colleagues at China First Capital, I’ve put together a list of ten questions laoban should expect to hear in a first meeting with a PE firm. The purpose: to give the laoban a quick sense of the scope and rigor of the PE investment process.   

Of course, in any first meeting with a professional PE firm, there will be many more than ten questions. It’s unlikely any PE would ask all – or even the majority – of the ten on the list. 

But, these owner-entrepreneurs are all outstanding problem-solvers. If they weren’t, they wouldn’t be running and owning the sort of businesses of interest to good PE investors. 

So, the questions are really just a catalyst, to get the laoban to think about how a sophisticated investor will evaluate his business. In other words, to see his business from the outside looking in. This is like refraction, where shifting the angle changes the quality of the light. 

Here are the ten questions.  There are no right answers, of course. Only a right mindset.      

1.  How much of your equity are you selling?
   
2. What will you use this equity investment for?
   
3. When do you hope to complete this fund‐raising?
   
4. When will you IPO?
   
5. What are you looking for besides capital from an investor?
   
6. How do you think you can double or triple your profits?
   
7. How much is your valuation?
   
8. Who are your competitors and what are your competitive edges?
   
9. Can you please explain your strategy for growing faster than your competitors?
   
10. Please give me brief summary of the jobs and the past experience of the most important members of your management team?