China Private Equity

I get asked occasionally by private equity firm guys how CFC gets such stellar clients. At least in one case, the answer is carved fish, or more accurately my ability quickly to identify the two murky objects (similar to the ones above) carved into the bottom of a ceramic dish. It also helped that I could identify where the dish was made and when.

From that flowed a contract to represent as exclusive investment bankers China’s largest and most valuable private GPS equipment company in a USD$30mn fund-raising. It’s in every sense a dream client. They are the most technologically adept in the domestic industry, with a deep strategic partnership with Microsoft, along with highly-efficient and high-quality manufacturing base in South China, high growth and very strong prospects as GPS sales begin to boom in China.

Since we started our work about two months ago, several big-time PE firms have practically fallen over themselves to invest in the company. It looks likely to be one of the fastest, smoothest and most enjoyable deals I’ve worked on.

No fish, no deal. I’m convinced of this. If I hadn’t correctly identified the carved fish, as well as the fact the dish was made in a kiln in the town of Longquan in Zhejiang Province during the Song Dynasty, this company would not have become our client. The first time I met the company’s founder and owner, he got up in the middle of our meeting, left the room and came back a few minutes later with a fine looking pale wooden box. He untied the cord, opened the cover and allowed me to lift out the dish.

I’d never seen it before, but still it was about as familiar as the face of an old teacher. Double fish carved into a blue-tinted celadon dish. The dish’s heavy coated clear glaze reflected the office lights back into my eyes. The fish are as sketchily carved as the pair in the picture here (from a similar dish sold at Sothebys in New York earlier this year), more an expressionist rendering than a precisely incised sculpture.

It’s something of a wonder the fish can be discerned at all. The potter needed to carve fast, in wet slippery clay that was far from an ideal medium to sink a knife into. Next came all that transparent glaze and then the dish had to get quickly into a kiln rich in carbon gas. The amount of carbon, the thickness and composition of the glaze, the minerals dissolved in the clay – all or any of these could have contributed to the slightly blue-ish tint, a slight chromatic shift from the more familiar green celadons of the Song Dynasty.

All that I knew and shared with the company’s boss, along with remarking the dish was “真了不起”, or truly exceptional. It’s the finest celadon piece I’ve seen in China. Few remain. The best surviving examples of Song celadon are in museums and private collection outside China. I’m not lucky enough to own any. But, I’ve handled dozens of Song celadons over the years, at auction previews of Chinese ceramic sales at Sotheby’s and Christie’s in London and New York. The GPS company boss had bought this one from an esteemed collector and dealer in Japan.

The boss and I are kindred spirits.  He and I both adore and collect Chinese antiques. His collection is of a quality and breadth that I never imagined existed still in China. Most antiques of any quality or value in China sadly were destroyed or lost during the turbulent 20^th century, particularly during the Cultural Revolution.

The GPS company boss began doing business in Japan ten years ago, and built his collection slowly by buying beautiful objects there, and bringing them home to China. Of course, the reason Chinese antiques ended up in Japan is also often sad to consider. They were often part of the plunder taken by Japanese soldiers during the fourteen brutal years from 1931 to 1945 when they invaded, occupied and ravaged parts of China.

Along with the celadon dish, the GPS boss has beautiful Liao, Song, Ming and Qing Dynasty porcelains, wood and stone carvings and a set of Song Dynasty paintings of Buddhist Luohan. In the last few months, I’ve spent about 20 hours at the GPS company’s headquarters. At least three-quarters of that time, including a visit this past week, was spent with the boss, in his private office, handling and admiring his antiques, and drinking fine green tea grown on a small personal plantation he owns on Huangshan.

I’ve barely talked business with him. When I tried this past week to discuss which PE firms have offered him money, he showed scant interest. If I have questions about the company, I talk to the CFO. Early on, the boss gifted me a pretty Chinese calligraphy scroll. I reciprocated with an old piece of British Wedgwood, decorated in an ersatz Chinese style.

Deal-sourcing is both the most crucial, as well as the most haphazard aspect of investment banking work. Each of CFC’s clients has come via a different route, a different process – some are introduced, others we go out and find or come to us by word-of-mouth.  Unlike other investment banking guys, I don’t play golf. I don’t belong to any clubs. I don’t advertise.

Chinese antiques, particularly Song ceramics,  are among the few strong interests I have outside of my work.  The same goes for the GPS company boss. His 800-year old dish and my appreciation of it forged a common language and purpose between us, pairing us like the two carved fish. The likely result: his high-tech manufacturing company will now get the capital to double in size and likely IPO within four years, while my company will earn a fee and build its expertise in China’s fast-growing automobile industry.  

Anyone seeking to succeed in investment banking in China should live by one rule alone: it’s not who you know, but how well you know them. In China, more than any other country where I’ve worked, the professional is also the personal. Comradeship, if not friendship, is always a necessary precondition to doing business together. If you haven’t shared a meal – and more importantly, shared a few hundred laughs – you will never share a business deal. Competence, experience, education and reputation all matter, of course. But, they all play supporting roles.

The stereotypical hard-charging pompous Wall Street investment banker wouldn’t stand much of a chance here. A “Master of the Universe” would need to master a set of different, unfamiliar skills. Personal warmth, ready humor and a relaxed and somewhat deferential attitude will go a lot farther than spreadsheet modeling, an Ivy League MBA and financial dodges to increase earnings-per-share.

I’ve been around a fair bit in my +25 year business career, doing business is over 40 countries and managing companies in the US, Europe and Asia. Everywhere, it helps to be likeable, attentive, courteous. We all prefer working with people we like.  But, since moving to China and opening a business, I’ve learned things work differently here. Making money and making friends are interchangeable in China. You can’t do the first without doing the second.

Investment banking is so personal in China because most private Chinese companies, from the biggest on down, are effectively one-man-shows, with a boss whose authority and wisdom are seldom challenged. Usually, there is  no “management team” in the sense this term is applied in the US and Europe. A Chinese boss is the master of all he (or often she, as women entrepreneurs are common here) surveys.

A substantial percentage of my time is spent getting to know, and winning the friendship, of Chinese bosses. This alone makes me a lucky guy. Without fail, the bosses I meet are smart, gifted, able, hospitable, warm. We don’t select for these qualities. They are prerequisites for success as a private business in China.

Bosses are also usually guarded about meeting new people. It comes with the territory. Anyone with a successful business in China is going to be in very large demand from a very large “catchment pool”, including just about everyone in the extended circle of the boss’s friends, relatives, employees, suppliers, political contacts. Everyone is selling or seeking something. Precious few will succeed. Being a boss in China requires enormous stamina, to deal with all those making a claim on your time, and a gift for saying “No” in ways that don’t offend.

For investment bankers, successful deal generation in China will usually follow an elliptical path. The biggest mistake is to start pitching your company, or a transaction, the moment you meet a prospective client. You need first to win the boss’s trust and friendship, then you can discuss how to work together. In my working life in China, it’s axiomatic that in a first meeting with a company boss, one or the other of us will say, “我们先做朋友”,  or “let’s become friends be first”. It’s not some throwaway line. It’s an operating manual.

The Chinese use a specific word to define the engagement between an investment banker and client. It speaks volumes about the way new business is won here. It’s “合作” or cooperation. You don’t work for a Chinese company, you cooperate with it. There’s got to be a real personal bond in place, a tangible sense of shared purpose and shared destiny.

I could probably teach a class in the cross-cultural differences of investment banking in China and the US. I’ve not only been active in both places, I’ve been on both sides of the table. Before starting CFC, I was CEO of an American company that retained one of the most renowned investment banks in the US to handle an M&A deal for us. At that company, we had a deep senior management team, including two supremely capable founders. We dealt individually and collectively with the investment bank, which had a similarly-sized team assigned to the project.

The relationships were professional, cordial. But, the investment bankers never made any real effort to become my friend, nor did I want them to. Rarely, if ever, did discussions veer away from how to create the conditions to get the best price. The bankers were explicitly pursuing their fee, and we were pursuing our strategic goal.

The deal went pretty smoothly, following a tightly-scripted and typical M&A process. The investment bank’s materials and research were first-rate, and they had no difficulty getting directly to decision-makers at some of the largest software companies in the world. They performed with the intricate precision and harmony of the Julliard Quartet.

I can count the number of times I sat down with the bankers for a nice meal where business was not discussed. Or the number of times when the meeting room rang with peals of friendly laughter. Zero. Both would be unthinkable in China.

Here, a deal is more than just a deal. Price is not the only, or even the main objective. Instead, as an investment banker, you must knit souls together, their lives, fortunes, careers, goals and temperaments. There is no spreadsheet, no due diligence list, no B-school case study, no insider jargon to consult.

Be likeable and be righteous. But. above all, do not be transparently or subliminally motivated mainly by personal greed. A successful Chinese boss will smell that coming from miles away, and recoil. You’ll rarely get past “ 您好” , the polite form of “hello”.

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CFC’s latest Chinese-language research report has just been published. The topic: M&A Strategy for Chinese Private Companies. Our conclusion: propelled by rapidly-growing domestic market and the continuing evolution of China’s capital markets, China will overtake the USA within the next decade as the world’s largest and most active market for mergers and acquisitions.

The report, titled “ 并购- 中国企业的成功助力”，can be downloaded by clicking here.

The report identifies five key drivers that fueling M&A activity among private sector companies in China.  They are: (1) a once-in-a-business-lifetime opportunity to seize meaningful market share in the domestic market; (2) the coming generational shift as China’s first generation of entrepreneurs moves toward retirement age; (3) a widening valuation gap between private and publicly-traded companies; (4) regulatory changes that will make it easier to pay for acquisitions using shares as well as cash; (5) increased access to IPO market in China for companies that have augmented organic growth through strategic M&A.

Several case studies from our work feature in the report, including a cross-border M&A deal we are doing, and one purely domestic trade sale. We take on a select number of M&A clients, and work as a sell-side advisor.

M&A in China has myriad challenges that do not often arise in other parts of the world. One we see repeatedly is that few Chinese acquirers have in-house M&A teams or investment banks on call to provide help with structure and valuation. Talking with anyone less than the company chairman is often a waste of time.

Another unique hurdle: “GIGO DD” or, more prosaically, “garbage in, garbage out due diligence.” Potential acquirers unfortunately will often start their industry research by doing a Chinese language web search using Baidu. There is a lot of dubious stuff out there that is given some credence, including phony websites and bizarre claims posted to people’s personal blogs or chatrooms.

In the cross-border deal we’re working on, several companies backed out of the process after finding Chinese companies claiming on their corporate website to make equipment identical to our client’s. This convinced these potential bidders that our client had technology and assets of little value. We actually took the time, unlike the potential acquirers, to call the phone numbers on these websites, posing as potential customers. None of the companies had any similar equipment for sale or in development. The material on their websites was bogus.

Market data from online sources is also usually specious. Few people, including lawyers, have working knowledge of how an M&A deal might impact a company’s plans for domestic IPO in China.

I’ve been inside some M&A deals in the US,  with their online data rooms, cloak-and-dagger codenames, and a precisely orchestrated bidding process. In China, the process is more unscripted.

Until recently, the only Chinese companies able and willing to do M&A were larger State-Owned Enterprises (SOE). The deals were done to buy oil and other natural resources on the stock market, or to acquire European brand names to put on Chinese-made products. Those deals include Sinopec’s purchase of shares in Canadian company Addax， CNOOC’s failed acquisition of UnoCal, TCL’s purchase of Thomson TVs and Alcatel phones, and Nanjing Automotive’s buying the MG brand.

These kind of deals will likely continue. But, in the future, M&A deals will become more numerous, more necessary for private entrepreneur-founded companies and have more complex strategic goals.

M&A is one of only two ways for founders and shareholders to achieve exit. The other is IPO. But, the number of private companies who can IPO in China will always be limited. At the moment, the number is about 250 per year. Compare that to the 70 million or so private companies in China.

The IPO process creates a special competitive dynamic in China. The first company in an industry to become publicly-traded usually has a huge advantage over competitors. They disrupt the previous equilibrium in an industry.

This means there are only two choices for many entrepreneurs. Both choices involve M&A. If you aren’t going to become a public company or a competitor has already gone public, you need to consider selling your company. If you want to become a public company,  you will need to become an expert at buying other companies.

The economic destiny of China, and many of its better private companies, is M&A.

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Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

1. China’s current stage of six-pronged development (Slide 2)  
2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9) 

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

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The private equity industry in China continues on its remarkable trajectory: faster, bigger, stronger, richer. CFC’s latest research report has just been published, titled “Private Equity in China 2011-2012: Positive Trends & Growing Challenges”. You can download a copy by clicking here.

The report looks at some of the larger forces shaping the industry, including the swift rise of Renminbi PE funds, the surging importance of M&A, and the emergence of a privileged group of PE firms with inordinate access to capital and IPO markets. The report includes some material already published here.

It’s the first English-language research report CFC has done in two years. For Chinese readers, some similar information has run in the two columns I write, for China’s leading business newspaper, the 21st Century Herald (click here “21世纪经济报道”) as well as Forbes China (click here“福布斯中文”) 

Despite all the success and the new money that is pouring in as a consequence, Chinese private equity retains its attractive fundamentals: great entrepreneurs, with large and well-established companies, short of expansion capital and a knowledgeable partner to help steer towards an IPO. Investing in Chinese private companies remains the best large-scale risk-adjusted investment opportunity in the world, bar none.

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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.

More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.

My firm has just published a Chinese-language research report on the topic, titled “民营企业上市规范问题”. You can download a copy by clicking here or from Research Reports page of the CFC website.

The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.

For English-only speakers, here’s a summary of some of the key points in the report:

1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.

Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai“ ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.

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I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.

What’s Behind China’s Reverse IPOs?

A dysfunctional financial system pushes companies toward awkward deals in America.

By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

The flow of money into private equity in China is fast becoming a deluge. Six months ago, new rules were introduced to allow the country’s insurance companies to invest up to 5% of their Rmb4.8 trillion of assets in PE funds investing in China. If fully invested, that would be Rmb240 billion ($36 billion) of new capital for an investment class that is already flooded with liquidity.  Insurance assets are growing by over 15% a year, which means at least another $5 billion a year available in coming years for PE investing.

The other fire hose of capital is the National Social Security Fund (NSSF), subject of a recent blog post of mine. The NSSF is pumping Rmb80 billion ($12 billion) into PE investing in China, and expects to add an additional $1.5 billion a year in new capital for same purpose. Never before, in the space of twelve months has so much new capital poured a single class of illiquid investing.

In part, these institutions are chasing returns. Insurance companies and the NSSF both have very large longer-term liabilities, mainly in the form of retirement pensions and life insurance policies. PE investing can jazz up overall returns for institutions that otherwise park their money in safe but tepid investments like government bonds.

PE investing in China has certainly been performing well lately. The more successful firms have been earning returns of +40% a year for investors. For insurance companies, that kind of performance (40% returns on 5% of its assets) would deliver 2% base annual return. For the NSSF, with up to 10% of its assets going to PE, the potential rewards would be higher.

The investments in PE also serve a patriotic purpose. By providing additional growth capital for Chinese entrepreneurs, PE investment should help increase employment and overall economic growth in China. The insurance companies are all majority state-owned.  The NSSF is a branch of government.  Invest carefully, earn a good return and contribute to building China. That summarizes the management goals for insurance companies and the NSSF alike.

Less clear is what overall effect of all this state-controlled money on the PE industry in China. Like any other asset class, the more capital that pours in, the lower the overall returns are likely to be. The insurance companies and NSSF aren’t the only – or even the main – source of capital for the PE industry. There is already billions of dollars available for PE firms from LPs in China, the US, Europe, Japan. By some estimates, as much as $30 billion in new capital has already flowed into PE firms over the last year for investment in China. This excludes the money from the NSSF and insurance companies.

All this new capital is enough to fund PE investments in over 5,000 companies, based on a typical PE deal size in China. Are there that many good deals out there? It’s hard to say. Overall,  I’m very bullish about the number of great private companies and great PE investment opportunities in China.

The big bottleneck is certain to be within the PE firms themselves. The good ones, currently, do anywhere from 10-15 deals a year, and look seriously at another 25- 40 companies. They don’t have the partners and skilled staff to review, close and manage many more deals than this a year. The irony here: while PE firms demand portfolio companies use PE capital efficiently and scale quickly after investment, PE firms generally have no such ability. Adding capital to PE firms is like adding salt to soup.  More is not necessarily better.

As the amount of capital has surged, the preferred deal size of the more successful PE firms in China has risen steeply, from $10 million per deal, to over $25 million now. But,  in China, bigger deals are not generally better deals. Often, the opposite is true. The best PE investment I know of, for example, was the $5 million investment Goldman Sachs made in Shenzhen pharmaceutical company Hepalink. Its investment rose 240 times in value, based on Hepalink’s IPO price last year.

More capital also can also skew the priorities and tame the animal instincts of PE firms. When money is easy to raise,  as it is now, PE firms can spend more time on this than hunting for great companies. It’s easy to understand why. For every $100 million they raise, a PE firm generally keeps $2 million in annual management fees. This management fee income keeps rolling in like an annuity, regardless of how well the PE firm is doing in its “day job” of putting capital to work on behalf of investors.

Insurance companies and NSSF can generally negotiate a lower management fee. But, the incentive is still there for PE firms to focus on raising money rather than investing it.

The PE industry in China is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. My view: over the next decade, PE deals in China will produce more wealth for entrepreneurs and investors that any other major asset class anywhere in the world. Anything less will mean many opportunities in China were squandered rather than seized.

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In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.

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For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

1. Valuation, p/e multiples
2. IPO approval process – cost and timing of planning an IPO
3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.

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CFC has just published its latest Chinese-language research report. The title is 《私募基金如何创造价值》, which I’d translate as “How PE Firms Add Value ”.

You can download a copy here:  How PE Firms Add Value — CFC Report. 

China is awash, as nowhere else in the world is,  in private equity capital. New funds are launched weekly, and older successful ones top up their bank balance. Just this week, CDH, generally considered the leading China-focused PE firm in the world, closed its fourth fund with $1.46 billion of new capital. Over $50 billion has been raised over the last four years for PE investment in China. 

In other words, money is not in short supply. Equity investment experience, know-how and savvy are. There’s a saying in the US venture capital industry, “all money spends the same”. The implication is that for a company, investment capital is of equal value regardless of the source. In the US, there may be some truth to this. In China, most definitely not. 

In Chinese business, there is no more perilous transition than the one from a fully-private, entrepreneur-founded and led company to one that can IPO successfully, either on China’s stock markets, or abroad. The reason: many private companies, especially the most successful ones, are growing explosively, often doubling in size every year.

They can barely catch their breath, let alone put in place the management and financial systems needed to manage a larger, more complex business. This is inevitable consequence of operating in a market growing as fast as China’s, and generating so many new opportunities for expansion. 

A basic management principle, also for many good private companies, is: “grab the money today, and worry about the consequences tomorrow”. This means that running a company in China often requires more improvising than long-term planning. I know this, personally, from running a small but fast-growing company. Improvisation can be great. It means a business can respond quickly to new opportunities, with a minimum of bureaucracy. 

But, as a business grows, and particularly once it brings in outside investors, the improvisation, and the success it creates, can cause problems. Is company cash being managed properly and most efficiently? Are customers receiving the same degree of attention and follow-up they did when the business was smaller? Does the production department know what the sales department is doing and promising customers? What steps are competitors taking to try to steal business away? 

These are, of course, the best kind of problems any company can have. They are the problems caused by success, rather than impending bankruptcy.

These problems are a core aspect of the private equity process in China. It’s good companies that get PE finance, not failed ones. Once the PE capital enters a company, the PE firm is going to take steps to protect its investment. This inevitably means making sure systems are put in place that can improve the daily management and long-term planning at the company. 

It’s often a monumental adjustment for an entrepreneur-led company. Accountability supplants improvisation. Up to the moment PE finance arrives, the boss has never had to answer to anyone, or to justify and defend his decisions to any outsider. PE firms, at a minimum, will create a Board of Directors and insist, contractually, that the Board then meet at least four times a year to review quarterly financials, discuss strategy and approve any significant investments. 

Whether this change helps or hurts the company will depend, often, on the experience and knowledge of the PE firm involved.  The good PE firms will offer real help wherever the entrepreneur needs it – strengthening marketing, financial team, international expansion and strategic alliances. They are, in the jargon of our industry, “value-add investors”.

Lesser quality PE firms will transfer the money, attend a quarterly banquet and wait for word that the company is staging an IPO. This is dumb money that too often becomes lost money, as the entrepreneur loses discipline, focus and even an interest in his business once he has a big pile of someone else’s money in his bank account.   

Our new report focuses on this disparity, between good and bad PE investment, between value-add and valueless. Our intended audience is Chinese entrepreneurs. We hope, aptly enough, that they determine our report is value-add, not valueless. The key graphic in the report is this one, which illustrates the specific ways in which a PE firm can add value to a business.  In this case, the PE investment helps achieve a four-fold increase. That’s outstanding. But, we’ve seen examples in our work of even larger increases after a PE round.

The second part of the report takes on a related topic, with particular relevance for Chinese companies: the way PE firms can help navigate the minefield of getting approval for an IPO in China.  It’s an eleven-step process. Many companies try, but only a small percentage will succeed. The odds are improved exponentially when a company has a PE firm alongside, as both an investor and guide.

While taking PE investment is not technically a prerequisite, in practice, it operates like one. The most recent data I’ve seen show that 90% of companies going public on the new Chinext exchange have had pre-IPO PE investment. 

In part, this is because Chinese firms with PE investment tend to have better corporate governance and more reliable financial reporting. Both these factors are weighed by the CSRC in deciding which companies are allowed to IPO. 

At their best, PE firms can serve as indispensible partners for a great entrepreneur. At their worst, they do far more harm than good by lavishing money without lavishing attention. 

The report is illustrated with details from imperial blue-and-white porcelains from the time of the Xuande Emperor, in the Ming Dynasty.

Two years back, I met the boss and toured the factory of a Shenzhen-based company called TMK Power Industries. They make rechargeable nickel-metal hydride, or Ni-MH,  batteries, the kind used in a lot of household appliances like electric toothbrushes and razors, portable “Dustbuster” vacuum cleaners, and portable entertainment devices like MP3 players. 

At the time, it seemed to me a good business, not great. Lithium rechargeable batteries are where most of the excitement and investment is these days. But, TMK had built up a nice little pocket of the market for the lower-priced and lower-powered NI-MH variety. 

I just read his company went public earlier this year in the US, through a reverse merger and OTCBB listing. I wish this boss lots of luck. He’ll probably need it.

Things may all work out for TMK. But, at first glance, it looks like the company has spent the last two years committing a form of slow-motion suicide. 

Back when I met the company, we had a quick discussion about how they could raise money to expand. I went through the benefits of raising private equity capital, but it mainly fell on deaf ears. The boss let me know soon after that he’d decided to list his company in the US.

He made it seem like a transaction was imminent, since I know he was in need of equity capital. Two years elapsed, but he eventually got his US listing, on the OTCBB, with a ticket symbol of DFEL. 

Here is a chart of share price performance from date of listing in February. It’s a steep fall, but not an unusual trajectory for Chinese companies listed on the OTCBB. 

From the beginning, I guessed his idea was to do some kind of reverse merger and OTCBB transaction. I knew he was working then with a financial advisor in China whose forte was arranging these OTCBB deals. I never met this advisor, but knew him by reputation. He had previously worked with a company that later became a client of mine. 

The advisor had arranged an OTCBB deal for this client whose main features were to first raise $8 million from a US OTCBB stock broker as “expansion capital” for the client. The advisor made sure there wouldn’t be much expanding, except of his own bank account and that of the stock broker that planned to put up the $8mn. 

Here’s how the deal was meant to work: the advisor would keep 17% of the capital raised as his fee, or $1.35mn.  The plan was for the broker to then rush this company through an expensive “Form 10” OTCBB listing where at least another $1.5 mn of the original $8mn money would go to pay fees to advisors, the broker,  lawyers and others. The IPO would raise no money for the company, but instead all proceeds from share sale would go to the advisor and broker. The final piece was a huge grant of warrants to this advisor and the stock broker that would leave them in control of at least 15% of the post-IPO equity. 

If the plan had gone down, it’s possible that the advisor and broker would have made 2-3 times the money they put up, in about six months. The Chinese company, meanwhile, would be left to twist in the wind after the IPO. 

Fortunately for the company, this IPO deal never took place. Instead, I helped the company raise $10mn in private equity from a first class PE firm. The company used the money to build a new factory. It has gone from strength to strength. Its profits this year will likely hit $20mn, four times the level of three years ago when I first met them. They are looking at an IPO next year at an expected market cap of over $500mn, more than 10 times higher than when I raised them PE finance in 2008. 

TMK was not quite so lucky. I’m not sure if this advisor stayed around long enough to work on the IPO. His name is not mentioned in the prospectus. It does look like his kind of deal, though. 

TMK should be ruing the day they agreed to this IPO. The shares briefly hit a high of $2.75, then fell off a cliff. They are now down below $1.50. It’s hard to say the exact price, because the shares barely trade. There is no liquidity.

As the phrase goes, the shares “trade by appointment”. This is a common feature of OTCBB listed companies. Also typical for OTCBB companies, the bid-ask spread is also very wide: $1.10 bid, and $1.30 asked. 

Looking at the company’s underlying performance, however, there is some good news. Revenues have about doubled in last two years to around $50mn. In most recent quarter, revenues rose 50% over the previous quarter. That kind of growth should be a boost to the share price. Instead, it’s been one long slide. One obvious reason: while revenues have been booming, profits have collapsed. Net margin shrunk from 13% in final quarter of 2009 to 0.2% in first quarter of 2010. 

How could this happen? The main culprit seems to be the fact that General and Administrative costs rose six-fold in the quarter from $269,000 to over $1.8mn. There’s no mention of the company hiring Jack Welch as its new CEO, at a salary of $6mn a year. So, it’s hard to fathom why G&A costs hit such a high level. I certainly wouldn’t be very pleased if I were a shareholder. 

TMK filed its first 10Q quarterly report late. That’s not just a bad signal. It’s also yet another unneeded expense. The company likely had to pay a lawyer to file the NT-10Q to the SEC to report it would not file on time. When the 10Q did finally appear, it also sucked money out of the company for lawyers and accountants. 

TMK did not have an IPO, as such. Instead, there was a private placement to raise $6.9mn, and in parallel a sale of over 6 million of the company’s shares by a variety of existing shareholders. The broker who raised the money is called Hudson Securities, an outfit I’ve never heard of. TMK paid Hudson $545,000 in fees for the private placement, and also issued to Hudson for free a packet of shares, and a large chunk of warrants.

Hudson was among the shareholders looking to sell, according to the registration statement filed when the company completed its reverse merger in February. It’s hard to know precisely, but it seems a fair guess that TMK paid out to Hudson in cash and kind over $1mn on this deal. 

The reverse merger itself, not including cost of acquiring the shell, cost another $112,000 in fees. At the end of its most recent quarter, the company had all of $289,000 in the bank. 

These reverse merger and OTCBB deals involving Chinese companies happen all the time. Over the last four years, there’s been an average of about six such deals a month.

This is the first time – and with luck it will be the only time – I actually met a company before they went through the process. Most of these reverse merger deals leave the companies worse off. Not so brokers and advisors. 

Given the dismal record of these deals, the phrase 美国反向收购 or “US reverse merger” , should be the most feared in the Chinese financial lexicon. Sadly, that’s not the case.

Since 2005, 380 Chinese companies have executed reverse mergers in the US. They did so, in almost all cases, as a first step towards getting listed on a major US exchange, most often the NASDAQ. Yet, as of today, according to a recent article in Dow Jones Investment Banker, only 15% of those Chinese companies successfully “uplisted” to NASDAQ. That’s a failure rate of 85%. 

That’s a rather stunning indictment of the advisers and bankers who promote, organize and profit from these transactions. The Chinese companies are left, overwhelmingly, far worse off than when they started. Their shares are stuck trading on the OTCBB or Pink Sheets, with no liquidity,  steep annual listing and compliance fees, often pathetically low valuations,  and no hope of ever raising additional capital. 

The advisors, on the other hand, are coining it. At a guess, Chinese companies have paid out to advisors, accountants, lawyers and Investor Relations firms roughly $700 million in fees for these US reverse mergers. As a way to lower America’s balance of payments deficit with China, this one is about the most despicable. 

You would think that anyone selling a high-priced service with an 85% failure rate would have a hard time finding customers. Sadly, that isn’t the case. This is an industry that quite literally thrives on failure. The US firms specializing in reverse mergers are a constant, conspicuous presence as sponsors at corporate finance conferences around China, touting their services to Chinese companies.

I was at one this past week in Shenzhen, with over 1,000 participants, and a session on reverse mergers sponsored by one of the more prominent US brokerage houses that does these deals. The pitch is always the same: “we can get your company listed on NASDAQ”. 

I have no doubt these firms know that 85% of the reverse mergers could be classified as expensive failures, because the companies never migrate to NASDAQ.  Equally, I have no doubt they never disclose this fact to the Chinese companies they are soliciting. I know a few “laoban” (Chinese for “company boss”)  who’ve been pitched by the US reverse merger firms. They are told a reverse merger is all but a  “sure thing”. I’ve seen one US reverse merger firm’s Powerpoint presentation for Chinese clients that contained doctored numbers on performance of firms it brought public on OTCBB.  

Accurate disclosure is the single most important component of financial market regulation. Yet, as far as I’ve been able to determine, the financial firms pushing reverse mergers offer clients little to no disclosure of their own. No other IPO process has such a high rate of failure, with such a high price tag attached. 

Of course, the Chinese companies are often also culpable. They fail to do adequate due diligence on their own. Chinese bosses are often too fixated on getting a quick IPO, rather than waiting two to three years, at a minimum, to IPO in China. There’s little Chinese-language material available on the dangers of reverse mergers. These kinds of reverse mergers cannot be done on China’s own stock exchanges. Overall knowledge about the US capital markets is limited. 

These are the points cited by the reverse merger firms to justify what they’re doing. But, these justifications ring false. Just because someone wants a vacation house in Florida doesn’t make it OK to sell them swampland in the Everglades. 

The reverse mergers cost China dear. Good Chinese SME are often bled to death. That hurts China’s overall economy. China’s government probably can’t outlaw the process, since it’s subject to US, not Chinese, securities laws. But, I’d like to see the Chinese Securities Regulatory Commission (中国证监会), China’s version of the SEC, publish empirical data about US reverse mergers, SPACs, OTCBB listings. 

There is not much that can be done for the 325 Chinese companies that have already completed a US reverse merger and failed to get uplisted to NASDAQ. They will continue to waste millions of dollars a year in fees just to remain listed on the OTCBB or Pink Sheets, with no realistic prospect of ever moving to the NASDAQ market.

For these companies, the US reverse merger is the capital markets’ version of 凌迟, or “death by a thousand slices”.

China’s private equity industry is on track to break all records in 2010 for number of deals, number of successful PE-backed IPOs, capital raised and capital invested. This record-setting performance comes at a time when the PE and VC industries are still locked in a long skid in the US and Europe.

According to my firms’s latest research report, (see front cover above)  the best days are still ahead for China’s PE industry. The Chinese-language report has just been published. It can be downloaded by clicking this link: China First Capital 2010 Report on Private Equity in China

We prepare these research reports primarily for our clients and partners in China. There is no English version.

A few of the takeaway points are:

• China’s continued strong economic growth is only one factor providing fuel for the growth of  private equity in China. Another key factor that sets China apart and makes it the most dynamic and attractive market for PE investing in the world: the rise of world-class private SME. These Chinese SME are already profitable and market leaders in China’s domestic market. Even more important, they are owned and managed by some of the most talented entrepreneurs in the world. As these SME grow, they need additional capital to expand even faster in the future. Private Equity capital is often the best choice

• As long as the IPO window stays open for Chinese SME, rates of return of 300%-500% will remain common for private equity investors. It’s the kind of return some US PE firms were able to earn during the good years, but only by using a lot of bank debt on top of smaller amounts of equity. That type of private equity deal, relying on bank leverage, is for the most part prohibited in China

• PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the original PE firms in China anticipated, or can cope with. What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO

Our goal is to be a thought leader in our industry, as well as providing the highest-quality information and analysis in Chinese for private entrepreneurs and the investors who finance them.

One of my hobbies at work is collecting outrageous stories about the greed, crookedness and sleaze of some financial advisors working in China. Sadly, there are too many bad stories – and bad advisors – to keep an accurate, up-to-date accounting. 

Over 600 Chinese companies, of all different stripes,  are listed on the unregulated American OTCBB. The one linking factor here is that most were both badly served and robbed blind by advisors.

Many other Chinese companies pursued reverse mergers in the US and Hong Kong.Some of these deals succeeded, in the sense of a Chinese company gaining a backdoor listing this way. But, all such deals, those both consummated or contemplated, are pursued by advisors to put significant sums of cash into their own pockets. 

Talking to a friend recently in Shanghai, I heard about one such advisor that has set a new standard for unrestrained greed. This friend works at a very good PE firm, and was referred a deal by this particular advisor. I’ve grown pretty familiar with some of the usual ploys used to fleece Chinese entrepreneurs during the process of “fund-raising”. Usual methods include billing tens of thousands of dollars for all kinds of “due diligence fees”, phony “regulatory approvals” and unneeded legal work carried out by firms affiliated with the advisor.  

But, in this one deal my Shanghai friend saw, the advisor not only gorged on all these more commonplace squeezes, as well as taking a 7% fee of all cash raised, but added one that may be rather unique in both its brazenness and financial lunacy. The advisor had negotiated with the client as part of its payment that it would receive 10% of the company’s equity, after completing capital-raising. 

Let’s just contemplate the financial illiteracy at work here.  No PE investor would ever accept this, that for example, their 20% ownership immediately becomes 18% because of a highly dilutive grant to the advisor. It’s such a large disincentive to invest that the advisor might as well ask the PE firm to surrender half its future profits on the deal to put the advisor’s kids through college.

The advisor clearly was a lot more skillful at scamming the entrepreneur than in understanding how actually to raise PE money. The advisor’s total take on this deal would be at least 17% of the investor’s money, factoring in fees and value of dilutive share grant. 

By getting the entrepreneur to agree to pay him 10% of the company’s equity, along with everything else, the advisor raises the company’s pre-money valuation by an amount large enough to frighten off any decent PE investor. Result: the advisor will not succeed raising money, the entrepreneur wastes time and money, along with losing any real hope of every raising capital in the future. What PE firm would ever want to invest with an entrepreneur who was foolish enough to sign this sort of agreement with an advisor? 

This is perhaps the most malignant effect of the “work” done by these kinds of financial advisors. They create deal structures primarily to enrich themselves, at the expense of their client. By doing so, they make it difficult even for good Chinese companies to raise equity capital, now and in the future.  

I’m sure, based on experience, that some people reading this will place blame more on the entrepreneur, for freely signing contracts that pick their own pockets. No surprise, this view is held particularly strongly by people who make a living as financial advisors doing OTCBB and reverse merger deals in China.  This view is wrong, professionally and morally. 

In most aspects of business life, I put great stock in the notion of “caveat emptor”. But, this is an exception. The advisors exploit the credulity and financial naivete of Chinese entrepreneurs, using deception and half-truths to promote transactions that they know will almost certainly harm the entrepreneur’s company, but deliver a fat ill-gotten windfall to themselves. 

Entrepreneurs are the lifeblood of every economy, creating jobs, wealth and enhancing choice and economic freedom. This is nowhere more true than in China. Defraud an entrepreneur and, in many cases,  you defraud society as a whole.