China Private Equity

It wasn’t supposed to turn out this way. Shanghai has lost its leading position at the center of the private equity industry in China. Instead, Beijing has grabbed the mantle, and is now the city in China with the densest network of active, top tier PE firms.

Could this be an example of the failure of central planning? It’s certainly the case that Chinese governments for the last twenty years have pursued explicitly the goal of making Shanghai the financial capital of China. The frequently-cited analogy: Shanghai, like New York, would serve the center of finance and trade, while Beijing would more closely resemble Washington, as a less commercial, more politically-focused city.

For quite awhile, this division of power prevailed. Shanghai’s stock market became the country’s largest, acting as magnet for banks and brokerage companies. Many of the first PE firms to enter China followed along, setting up their main offices in Shanghai.

Beijing, meanwhile, remained something of a financial backwater. It attracted the headquarters of the largest state-owned companies (like China Mobile, Sinopec, China Telecom), but never developed a capital market of its own. Beijing-based PE firms, in the main, were several steps behind their Shanghai competitors.  The capital and top talent were concentrated in Shanghai.

Today, the axis has shifted. Beijing is clearly in the ascendant. The money, the people and the future of the PE industry in China all seem to be going Beijing’s way. This shift was not the result of any specific government policy benefitting Beijing’s PE firms.

In fact, it’s only in Shanghai where such inducements are in place. The local government in Pudong, for example, has made a special push to attract PE firms, offering them various tax breaks to locate there.

How did Beijing gain the upper hand? Two main factors stand out: China’s central government has become the most significant large new source of PE capital. Second, the locus of IPO activity is also shifting from international stock markets, principally Hong Kong and New York, to China’s domestic exchanges. This has elevated the importance of Beijing-based China Securities Regulatory Commission (CSRC, or证监会  in Chinese). It makes the decisions about which Chinese companies can IPO in China and when.

There is simply no comparison between the work of the CSRC and the US Securities and Exchange Commission (SEC), the institution on which it was loosely modeled. The SEC lets the market decide which companies should IPO. The CSRC is nowhere near that laissez-faire. It decides which companies, from which industries, with what kind of profit level should IPO, and when the IPO should take place.

Any PE firm that needs domestic IPOs to achieve an exit needs to know how the CSRC works, and when necessary, how to properly influence them. Beijing-based PE firms are in the right place to influence this key decision-maker in the process of gaining exit for their portfolio companies.

There is no rule that says investment funds from the central government should be managed in Beijing, by investment firms based there. But, in practice, that’s what’s happening. This is very noticeable when you look at the PE firms selected to received renminbi funds from China’s enormous National Social Security Fund (NSSF or 社保 in Chinese), which has over $100bn in total assets, and growing fast. It plans to invest around 10% of its assets in private equity and other alternative investments. This will soon make the NSSF the largest Limited Partner for private equity firms.

Of the 20 PE firms so far selected to receive NSSF funds, a significant majority are Beijing-based, including powerhouses like SAIF, CDH, Legend Capital, NewHorizon. In addition, the NSSF has chosen to provide capital to a group of domestic PE firms, including Brightstone .

The NSSF isn’t the only Chinese government body providing funding for PE firms. Two other powerful and cash-rich institutions, the National Reform and Development Commission (发改会 in Chinese) , and National Investment Commission (国资会)，are also playing a role steering capital to PE firms.

The more crucial advantage, however, is probably the Beijing firms’ deeper connections with the Beijing-based CSRC. Staging an IPO in China is a complex, time-consuming process and not terribly transparent process. It often requires many levels of central government involvement and approval. The CSRC is at the apex of this bureaucratic pyramid. It has the final say on which companies can IPO and when.

For a PE firm, building good relations with the CSRC is almost as important as choosing good companies to invest in. Those portfolio companies will have a better chance of a timely and successful IPO in China if their PE investor knows how the CSRC works, and how to push the approval process through to a successful conclusion. Beijing firms are usually best at working these and other levers of Chinese power. This skill trumps any advantage Shanghai may have as China’s official “financial capital”.

It’s a cumulative process:  the Beijing firms’ are growing richer and more skilled in the intricacies of Chinese decision-making and IPO planning. Their edge over Shanghai firms is therefore only likely to grow in coming years.

My company has felt the impact of this shift towards Beijing, and we’re responding to it. I’m certainly traveling there more and more. Our goal is to help clients become highly successful publicly-traded companies by arranging pre-IPO PE investment. The Beijing PE firms have a decided – and increasingly decisive – advantage.

They are well-integrated into the system that makes the key decisions in China, both by receiving funding from the central government and by building consistent and productive working relationships with the CSRC and other key agencies. We advise our clients to consider very strongly the advantages that Beijing PE firms hold.

Beijing has another key asset. The firms we work with are all well-led, with great people, both at partner level and below. For Chinese companies seeking PE financing, the road to success more often leads to and through Beijing.

In the history of business, there are no innovations more important, transformative, valuable and widely-used than Luca Pacioli’s. Yet, few know his name. He never made a fortune and likely spent most of his adult life in prayer and cloistered meditation. 

Pacioli was a 15th century Italian mathematician and monk who first codified the system of double-entry bookkeeping. This made modern corporate management possible, by providing a standardized and generally foolproof system for summarizing a business’s financial condition. Pacioli’s system of offsetting credits and debits remains very much the basis of all modern corporate accounting. 

I looked around, but couldn’t discover when double-entry bookkeeping, Pacioli’s brainchild, was first introduced to China. It is certainly pervasive now. The principles of corporate accounting, like mathematics,  don’t change as you move across national borders. In private equity investing, the process of assessing a company’s performance and attractiveness as an investment will be a function, ultimately, of its profitability and net asset value. Pacioli’s methods are the tools to determine both. 

Yet, there are times when I think Pacioli’s accounting principles are no more useful a tool in private equity investment in China than his fellow Italian Marco Polo’s travelogues are to current-day tourists visiting the Great Wall. They are better than nothing. But, you will still need to do a lot of your own strenuous legwork. 

The reason is that accounting principles are not widely applied in the management of many of the better private SME in China. They are entrepreneur-led businesses. Usually the most complete statement of the businesses financial worth is not to be found on a company balance sheet, but in the mind  of the entrepreneur. Some of this is by habit, other by design, to thwart any unwanted outsider, especially the taxman, from knowing exactly what is going on in a company. 

One example from my own work: I made a first visit to an excellent company, with a thriving retail business and brand that’s both well-established and well-known in large parts of China. I was immediately impressed and asked the finance director for the company’s last year’s revenues and profits. “I don’t know,” she replied. Quickly, it became clear she wasn’t being coy or secretive. She genuinely did not know. “Only the boss knows”, she explained, looking over at him. 

He looked momentarily baffled, as if the question had never been posed before, and then did the calculation aloud. He knew precisely how many products he manufactured last year, the average selling price, and unit profit. So with a little multiplication, we were able to get to a number. Turned out, revenues were well north of USD$65mn, and net profits over $7mn. Very solid numbers. We later brought in an accounting firm to do a trial set of financials, and in fact, the true figures were about 15% higher than that first calculation by the boss. Apparently, he hadn’t fully consolidated the results from an outsourced production facility. 

It’s a great company from every perspective – except if you’re trying to evaluate it quickly, using a statement prepared using Luca Pacioli’s principles. Anyone attempting to assess the company using such methods is going to hit a wall, right at the outset. 

The company, like many others of China’s best private firms, does not track its performance with a set of financials, or commission an annual audit. Management stays rigorously attuned to operational details, to cash in the bank, to inputs and outputs, to seizing any available economies to fatten its profit margin. Most often, none of this is ever summarized in a P&L or balance sheet. The boss doesn’t need it. He lives and breathes it every day. 

Any PE firm looking to evaluate the company needs to do the same  – spend time at the company, with the boss, in the factory, and get a feel for how the business is running. If you make it a precondition before any visit to have a set of financials, you’re going to be spending a lot of time anchored to your desk, or visiting only companies that are so hard-up for cash that they’ve spent a good chunk of money getting financials done, to please potential investors. Even in China, an audit done by a local Chinese accounting firm can cost well over USD$50,000. I’d rather have that money spent where it can do more good, like building the business.  

Some good private Chinese companies do have audited financials. They are usually the ones with sizable bank loans. An annual audit is often a covenant of such loans. But, in my experience, most good Chinese companies, with little or no debt and no urgent need to attract investors will not have the sort of financials that some PE firms want to see at the start. 

In China, a set of financials should not be an absolute prerequisite for PE investors. The first step should be to understand the business operationally, and then pay a visit, if the industry and business model both seem attractive. You learn more in two hour site-visit than you would in two days combing through financials.  Besides, any PE firm will commission its own audit, usually by a Big Four accounting firm, before it invests, during the due diligence phase. So, no one is committing money blindly. Eventually, Luca Pacioli’s principles will be put to work. The only issue is whether this is a first step, or one that comes later in the process. 

Accounting rules have enormous value.  Double-entry bookkeeping has never been improved upon, in the 500 years since Pacioli wrote the rules. But, in private equity investment in China, an over-reliance on financial statements, especially as a first-step in getting to know a company, will distort more often than it clarifies. As brilliant as he was, Luca Pacioli could not have anticipated the singular conditions and management style of the current generation of China’s successful private entrepreneurs. 

For 18 months or so,  until last month, I tried burning my work candle at both ends. The goal was to play a constructive role both as Chairman of China First Capital, and CEO of Awareness Technologies. For me, it’s been something of a dream come true, this chance to work with two great companies, at different points in their lifecycle, in wholly different industries, with different home markets, different customers, different languages, and vastly different business models.  So much the better. 

It’s also exposed, in way that nothing else ever quite has, just how limited my managerial skills are. They are, at best, barely adequate for managing one business. Cleaved in two, they are woe-begotten. It probably also helps explain why bigamy never really caught on. Attention divided is attention corrupted. 

Or so I thought, until I began spending time with one supremely talented entrepreneur in China. He’s the boss of at least four different companies. There could be more, for all I know. Each time we meet, he mentions, in passing, another business that he founded and runs. Other than the fact they’re all based in China, they are all as different from one another as chalk and cheese. This entrepreneur owns and manages a very consumer goods company, a mining business, an advertising agency and a high-technology business.

And when I say “manage”, I mean manage. He’s not some absentee landlord. He spends significant time with each, and established each to seize what is a very large market opportunity. I only know in detail one of these companies, and it’s outstanding. My sense is that the others are no less so. 

So, how does this one guy do it? For one thing, he’s probably a lot smarter, and certainly more locked-in and ambitious than I am. He sees the world, so far as I can tell, as a vast and intricate delta, of multiple earning streams and innumerable opportunities for profit. He grabs only those that he knows he can readily seize – by being clearer, smarter, and richer than any competitor. 

Me, I look in my business life more for purpose than for profit, for the chance to work on large and complex problems, rather than ways to make a killing. It’s probably why I’ll never be as rich, or as managerially capable, as this Chinese businessman. Some businessmen enter new areas for the very sound reason of diversifying their sources of wealth.

This businessman does so because he visualizes the world as a series of P&L statements. He sees (better than anyone I’ve ever met) where the money is. Then he goes for it. He also chooses businesses that let him maximize his managerial skills, by setting a concrete direction, funneling in the capital, hiring strong management, and then waiting for the money to flow. 

Knowing him more and more, I’m convinced he’d never have entered the two businesses I’m now involved with: investment banking and enterprise software. Investment banking, especially for Chinese SME,  has too many moving parts, too many vagaries (for example, of market prices and investor predilections); enterprise software is crowded, and competitive, prone to technological disruption,  and has many smart people chasing the same limited supply of dollars. 

As I said, I like challenge. He likes making money. 

The kicker here is that it turns out, we need each other. I need him, because my investment banking business thrives by having the very best Chinese entrepreneurs as clients. He needs me to help him get additional capital to build the most promising of his businesses. I am equally confident we can get him that capital as I am that he will put it to very productive use, and so earn his investor a fortune. 

Of all the entrepreneurs I work with, this guy is the one that I’m most awed by, probably because he is so obviously so much better at this “CEO multi-tasking” than I am. He is very comfortable in his skin, and clearly having a great time in life.  It’s a joy to be a small part of his intricate, expansive and beautifully-engineered business empire.

Despite my fourteen years living in London,  I needed to fly all the way back to that city this week, from China, to finally get a look at Westminster Central Hall, a stately stone pile across the street from the even statelier, stonier pile that is Westminster Abbey. Central Hall does double duty, both as a main meeting place for British Methodists, and also as an impressive venue for conferences, including the first meeting of the United Nations in 1946. 

This week, it was site of the annual Boao Forum for Asia International Capital Conference. I flew in to attend, and participate in a panel discussion on private equity in China. The Boao Forum is something like the more renowned Davos Forum, but with a particular focus on Asia and China. This annual meeting focused on finance and capital, and drew a large contingent of about 120 Chinese officials and businesspeople, along with an equal number of Western commercial bankers, lawyers, accountants, investors, politicians, academics and a few other investment bankers besides me. 

Central Hall is crowned by a large domed ceiling, said to be the second-largest in the world. I enjoyed sending back a brief live video feed to my China First Capital colleagues in Shenzhen, whirling my laptop camera up towards the dome, and then down to show the conference. It was also the first time any of my colleagues had seen me in a suit. 

The weather was a perfect encapsulation of British autumn climate, with blustery and frigid winds, occasional radiant sunshine and torrential rain. It was my first trip back to London in over two years, and nothing much had changed. What a contrast to China, where in two years, most major cities seem to undergo a radical facelift. 

“How can a non-Chinese invest in Chinese private company?” It was a straightforward question, by a London-based money manager, for the panel I was on. Straightforward, even obvious, but it was actually one I’d never really considered before, to my embarrassment. In my talk (see Powerpoint here: http://www.chinafirstcapital.com/blog/wp-content/uploads/2009/08/trends-in-private-equity.pdf) , I made the case about why Chinese SME are among the world’s best investment opportunities for private equity firms.  It’s an argument I’m used to making to conference audiences in China. This is the first time I’ve done so anywhere else. The question, though, made me feel a bit like a guy telling his friends about the new Porsche Carrera for sale for $8,000, but then saying, “unfortunately, you’re not allowed to buy one.” 

The reality is that it’s effectively impossible for a non-Chinese investor, other than the PE firms we regularly work with,  to buy into a great private Chinese SME. For one thing, the investor would need renminbi to do so, and there’s no legal way to obtain it, for purposes like this. Even if you found a way around that problem, you’d face an even steeper one when you wanted to exit the investment and convert your profits back into dollars or sterling. 

The money manager came up to me later, and I could see the vexation in her eyes. I had persuaded her there were great ways for investors to make money investing in SME in China. Disappointingly, her clients aren’t allowed to do so. Cold comfort was all I could offer,  pointing out the same basic problem exists for any non-Chinese seeking to buy shares quoted on the Shenzhen and Shanghai stock markets. 

It’s a reasonable bet that China eventually will liberalize its exchange rate controls and ultimately allow freer convertibility of the renminbi. But, that doesn’t exist now. As a result, financial investment in renminbi in China is, for the most part, reserved exclusively for Chinese. Unfair? It must seem that way to the sophisticated, well-paid money managers in London, who these days have few, if any,  similarly “sure fire” investment options for their clients. 

China is, itself, awash in liquidity, and sitting on a hoard of over $2 trillion in foreign exchange reserves. So, there really is no shortage of capital domestically. Allowing foreign investors in, of course, would increase the capital available to finance the growth of great companies. But,  it will also add to the mountain of foreign reserves and put more upward pressure on the renminbi. That’s the last thing Chinese authorities need at the moment. So, most of the best investment opportunities in China are likely to remain, for quite a lot longer, open only to Chinese investors. 

Overall, this is a very good time to be Chinese. By my historical reckoning, it’s the best since at least the Tang Dynasty over 1,000 years ago. China has changed out of all recognition over the last 30 years, creating enormous material and social gains. That beneficial change, if anything, is accelerating. The fact Chinese also have some of the world’s best investment opportunities to themselves is just another dividend from all this positive change. 

If I were a money manager, I’d also be asking myself “how can I get some of this?” But, I’m not a money manager, and I formulate things very differently. I’m so happy and privileged to have a chance to help some of China’s great private entrepreneurs. Me and my team invest all our waking hours and all our collective passion in this. We are rewarded daily, by the trust put in us by these entrepreneurs, and by our very small contribution to their continued success. That’s more than adequate return for me.

I guess I’m not cut out for purely financial investing. 

My CFC colleagues just completed our latest research report, on investment banking. It’s titled “投资银行的重要性”. A copy can be downloaded here: 

Download China First Capital Report on Investment Banking

The report examines the history, structure and central role of investment banks in raising capital for companies. Like other CFC reports, this one was meant to add meaningfully to the quality of information available in Chinese on financial topics relevant to SME owners and other private sector entrepreneurs. It’s a part of our work that I take special pleasure in. It can widen the circumference of our impact and contribution, beyond the relatively small group of CFC clients and the PE firms that finance them. 

We want the reports to be read widely, and to have some staying power. In choosing topics for these reports, we’re guided most strongly by our daily interactions with Chinese entrepreneurs, by the questions they raise, and problems they confront. So it is with the latest report. 

Investment banking isn’t well-understood in China, for the most part. There’s a lot of pigeonholing. Investment banks are primarily known for their IPO work, and not much else. The core function of investment banking – raising capital for companies –  is often missed.

This lapse speaks volumes about a larger, endemic problem in Chinese business: a shortage of growth capital among private businesses,  and an accompanying lack of knowledge how to raise it. 

Equity capital is used far less in China than the US to finance corporate activity. Bank loans could potentially fill the void somewhat, but they are very difficult for private Chinese companies to obtain from the country’s state-owned banks. The result: private companies under-invest and so grow far more slowly than market opportunities warrant. 

Of course, our new Chinese-language report on investment banking isn’t going to untangle this mess. Its aim is far more modest: to provide research and a rationale for investment banks’ central role in the capital-raising process.

Chinese securities regulations do not allow private domestic companies to issue preferred shares.  It does not sound particularly problematic, since preferred shares are not all that common anywhere. And yet, this regulatory quirk has serious unintended consequences. It is holding back the flow of private equity and venture capital investment into promising Chinese companies, particularly those with more than one shareholder. 

Preferred shares earn their name for a reason. These shares enjoy certain preferences over common shares, most often greater voting power and better protection in the event of bankruptcy. Preferred shares are the main mechanism through which venture capital and private equity firms invest in private companies. In general, when a PE or VC firm invests, the company receiving the investment creates a special class of preferred shares for the PE or VC. These preferred shares will have a raft of special privileges, above and beyond voting rights and liquidation preference. The theory is, the preferred shares level the playing field, giving the PE or VC firm more power to control the actions of the company, particularly how it uses the VC money,  and so protect its illiquid investment. 

Take away the ability to issue preferred, as is the case in China, and things begin to get much trickier for PE and VC investment. PE and VC firms are loathe to invest in ordinary common shares, since this gives them little of the protection they need to fulfill properly their fiduciary duty to their Limited Partners. There are, of course, all kinds of clever solutions that can be and often are employed to get around this problem in China. For example, the PE or VC firm can ask their very clever lawyers to craft a special shareholders agreement, to be signed by the company it’s investing in, that gives the PE or VC firm the same special treatment conferred by preferred shares. 

The problem here, though, is the legal enforceability of a shareholder agreement is not cut-and-dried.  A basis of most securities law, in China and elsewhere, is that all shareholders holding the same class of shares must be treated equally. In other words, if a PE or VC firm has ordinary common shares, it can’t get better treatment and more rights than any other common shareholder. 

What happens if a PE or VC firm’s shareholder agreement conflicts with this principle of equal treatment? China’s legal system is evolving, and precedent is not unequivocally clear. But, in general, the law takes precedence over any contract. In other words, if it comes down to a court fight, the PE or VC firm might find its shareholders agreement invalidated. 

This is not some remote likelihood, particularly if the company has more than just the founder and the PE or VC firm as shareholders. The “unpreferred” common shareholders have every right and many reasons to feel disadvantaged if they are deprived the same rights enjoyed by a VC firm also holding common shares.

There are many scenarios when this could lead to litigation, not just if the company runs into trouble, and shareholders end up fighting over how to divide whatever assets remain There’s also a big chance of legal mischief if the company does splendidly well. Let’s say the company is preparing for an IPO, and a shareholders agreement gives the VC firm special rights to have their shares registered and fully tradeable. This is a fairly common element in shareholders agreements. Other common shareholders would have ample reason to object, if their shares can’t be liquidated at the same time.  

Sometimes in business, legal uncertainty can be useful In this case, though, there are no clear winners. Anything that makes PE or VC firms less likely to invest disrupts the flow of capital to worthy businesses. That’s the situation now in China, with preferred shares disallowed and much uncertainty surrounding the legality of shareholders agreements. 

I have no special insight into why Chinese regulators have outlawed preferred shares for private domestic companies, or whether they are contemplating a change. But, a change would be beneficial. Most likely, the prohibition of preferred shares was designed to stop private companies from fleecing their unsuspecting equity-holders. In other words, the motive is sound. But, if the result is less growth capital available for successful young Chinese companies, the medicine ends up occasionally killing the patient. That doesn’t serve anyone’s interests: not entrepreneurs, nor investors, nor the country as a whole. 

 There are ways to give common shareholders some protection while still allowing private companies to create preferred shares. Ultimately, these common shareholders will likely benefit from the injection of PE or VC money into a company they’ve also invested in.  A shortage of capital is always a problem for growing companies, but it’s a particularly acute one in China. The PE or VC firm will also usually play a much more active role than other shareholders in building value, giving these other shareholders a free ride. 

Like most, I invest to make money, not exercise voting rights. So, my preference as a common shareholder will be to let the preferred have whatever rights they deem important – as long as they are doing the heavy lifting and pushing hard to build profits. They bring the capital, track record and expertise that often makes all the difference between a successful company and a has-been. I prefer to invest for success, and that often means preferring the presence of preferred investors.

I’m a pretty even-tempered guy, for the most part. But, those who know me, or read this blog, will by now know that I have a rather lively contempt for the financial advisors who swarm all over China, coaxing Chinese SME to pay them huge sums to arrange an IPO. Most often, the IPO happens as quickly as possible, with maximum fees flowing to the advisors, often on the shabbiest, most illiquid and unregulated of all stock markets, the American Over-the-Counter Bulletin Board (OTCBB). 

So, it was with a mix of surprise and, to be honest, some annoyance that I found myself recently besieged by some of these same “financial advisors”, eager to become my friend and business partner. It happened at the PE Conference I attended in mid-July in Shanghai. I was there to give one of the keynote speeches. Overall, it was a great experience. The organizers were cordial and professional. The other speakers and panel-members were first-class. 

But, I occasionally felt like a bit of bait dangling on hook. At every break, I was approached by well-dressed and well-spoken people, eager to give me their business cards, and talk shop. It just so happened that the shop they wanted to talk about was how to revive their now-troubled business model of doing these quick and lucrative IPOs for Chinese companies. I quickly, and I hope politely, explained that they were anathema, and in my mind, deserved particularly excruciating forms of punishment for ruining so many otherwise-good Chinese businesses by promoting and profiting from these awful IPO deals. Boiling in oil perhaps?  

Now, sure, these people didn’t have any way of knowing how I felt about what they do. They’ve never seen my blog, or heard me hold forth on the subject. So, I guess they must have found my reaction a little extreme. But, it did put a more human face on this whole problem, which I believe to be the single worst aspect of China’s financial system, that unethical and unprincipled advisors run rampant here, and have succeeded in convincing so many Chinese companies to IPO for the wrong reasons, at the wrong time, at grotesque expense with disastrous results.   

To be honest, I was a little surprised at just how nice and professional many of these “financial advisors” at the conference seemed to be. They didn’t conform very well to my stereotype, which admittedly, was formed by a quick meeting with one of these advisors almost two years ago. This was the guy who had tried, and nearly succeeded, to lure a great Chinese company to destruction via a “Form 10 Listing” on the OTCBB. This company later became China First Capital’s first client. 

The advisors I met at the conference were mainly eager to talk about how much they liked and respected CFC’s approach, and how much they had to learn from us. What is it they say about flattery being the food of fools? Anyway, soon after, they usually then started pitching me on some company or other that they were trying to list. One of them explained that they were now trying to get into the business of raising PE capital for Chinese SME. Did I have any tips? 

In this case, my advice was to disclose to these SME their past record of copping fat fees for taking companies public, knowing these clients would likely wither and die after the IPO. 

One thing that did strike me, in talking to these guys, is that they all tended to use the same Chinese phrase to describe their clients: “上市公司”, which I’d translate as “an IPO company”. It’s actually quite apt.  They are in business to arrange IPOs, not generally to raise capital, or act as bankers or trusted long-term advisors. 

We have some similar kinds of organizations in the US, and they often delusionally will call themselves “investment banks”. What they are, more accurately, are IPO bucket shops. In China, they still mainly call themselves “FA”, short for “Financial Advisor”. 

By whatever name, these guys are likely to remain a problem in China for a long time. They will not go out of business just because I hectored them about the damage they’re doing to entrepreneurship in China.  There are too many of them, and too many good SME for them to prey upon. They are like a well-oiled machine for mangling good Chinese companies.

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I’m flying back from China as I write this, and bringing with me something of great value to me personally — even if I can’t claim to recognize every character. It’s the Chinese-language report prepared by my China First Capital colleagues on how a Chinese SME can avoid the quicksand and plan a successful IPO. Built on a first draft in English of mine, it’s written specifically for Chinese SME bosses. The report is called “如何选择上市的时机和地点”. 

Download Here: 如何选择上市的时机和地点 “When & Where to IPO for Chinese SME”

We prepared the report with the explicit goal to help SME bosses make more informed decisions in capital-raising and IPO. There’s been an acute lack of reliable, well-researched information in Chinese on this topic. We hope the report will improve this “information deficit”. 

For me personally, this is the most important report we’ve prepared thus far for SME bosses. As this blog has discussed at length recently,  Chinese SMEs have been victimized disproportionately by every form of IPO indignity, from US OTCBB listings, to reverse mergers, Malaysian IPOs, SPACs and other schemes promoted by the predatory bankers, lawyers and advisors that swarm around China. 

Indeed, there are few bigger risks to a successful Chinese SME than making the wrong decision and heeding the wrong advice on where and when to IPO. 

I’d welcome feedback on the report. You can email me at ceo@chinafirstcapital.com

For those who can’t read the report in Chinese, it provides a comprehensive summary of pluses and minuses for Chinese SME of listing on the US, Hong Kong and Chinese stock markets. It also discusses at length, with several case studies,  the damage done to good Chinese SME by OTCBB listings and reverse mergers in the US. The bad examples abound. 

Even if you can’t read the Chinese, I hope you’ll consider sending it on to those active in China’s capital markets, as well as to any Chinese businessmen contemplating a public offering.  Better Chinese-language information is the strongest antiseptic to kill off the bad deals and bad dealmakers in China. So, I hope all those with a genuine interest in promoting entrepreneurship in China will help spread the word.

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In recent years, a large percentage of all OTCBB IPOs have been for Chinese SME companies. This is largely because too many Chinese SME fall too easily into the pit of investment vipers – the lawyers, accountants and self-described “investment bankers” and “private equity investors” that promote these OTCBB listings, reverse mergers and other schemes concocted by advisors generally for their own self-enrichment.

Once caught in the trap, the prospects for the SME are generally pretty bleak. They’ll be bled of badly-needed cash to pay the advisors, bankers and lawyers their fees, and later, by the costs of remaining a listed company. The bosses come to learn that a “US IPO” isn’t at all what it’s cracked up to be when it takes place on OTCBB: there are no celebratory news reports, no huge sums flowing into their personal or corporate bank accounts, no boost in company prestige or brand awareness. At best, it turns out to be a very expensive lesson. At worst, it’s the transaction that leads to the company’s premature demise.

Of course, by the time the SME realizes the scale of the mistake it made by agreeing to IPO on OTCBB, the advisors, lawyers and bankers are all long gone. I’ve heard from a Chinese lawyer friend that these advisors will change their mobile phone numbers after the IPO so the SME boss can no longer contact them.

Indeed, the distinguishing characteristic of these advisors and bankers is their disregard for the future condition of the Chinese SMEs once they’ve done the OTCBB transaction. They have no stake in the long-term success of the company, because they cash out at IPO, and move onto their next victim, er client.

It is not unusual that advisors earn millions of dollars from these OTCBB deals. It may be the most successful and durable investment banking racket of all time. Hundreds of Chinese companies have been ensnared over the last seven years.

How has it gone on for so long? For one thing, the OTCBB is not regulated in any real sense of the word. So, the SEC has little or no power to crack-down. The larger factor, though, is the complete lack of adequate scrutiny by the Chinese SME bosses. They put their business’s future in the hands of a bunch of guys with a proven talent (and mile-long rap sheets) for destroying companies, not building them.

I’m constantly amazed that great Chinese SME bosses I’ve met will do no independent due diligence on financial advisors. They don’t ask for a full track record of past deals, or partner bios, or a list of satisfied past customers to consult. Everything is taken at face value, and appropriately enough, the common result is a very large loss of face for the Chinese boss, after these bad deals have closed, and the damage is calculated.

Even if a Chinese boss wanted to do some proper due diligence, it’s by no means simple. There’s a notable lack of good, current information about the OTCBB in Chinese. Chinese journalists don’t ever seem to write about it, perhaps because these IPOs take place outside China. I did a search of OTCBB on China’s main search engine, Baidu.com, and the top results included information that’s three to four years old, and a site called OTCBB.com.cn that offers very little information, and seems to be owned and run by the kind of advisory firm that specializes in (you guessed it) doing OTCBB listings of Chinese companies. You won’t find anything too useful here.

It doesn’t take a lot of digging, assuming one can speak some English and knows where to look, to discover information that should start alarm bells ringing loud enough to wake the dead. For example, the Chinese government doesn’t recognize the OTCBB as a legitimate stock market for many transactions. Here’s a kernel of disclosure language from the SEC filing of a Chinese company that listed on OTCBB. (Underlined for emphasis:)

“The stock portion of the purchase price of Weihe to Weihe’s stockholders because the delivery of shares of the Company’s common stock in connection with the acquisition of Weihe is not permitted pursuant to applicable PRC law, so long as the Company is listed and traded on the OTCBB, rather than an exchange recognized by the applicable PRC governmental authorities, such as Nasdaq, AMEX and the NYSE.”

Imagine for a second you’re a lawyer, working with a Chinese SME on a proposed OTCBB listing. You must know this fact, that the Chinese government doesn’t recognize that stock market as legitimate. What do you do? Do you exercise your duty-of-care, and tell the client of the danger of an OTCBB listing? Or, do you just gloss over it, so that the deal will go through and you’ll earn big legal fees?

No prizes for guessing which course many of the lawyers take who advise Chinese SME on OTCBB listing. This is why it’s not, in my mind, exaggerating to say that these advisors are often a disgrace to their professions.

What can be done about all of this? It’s already too late for hundreds of Chinese companies that went down this road. For the other thousands of good SME bosses, however, access to better information in Chinese is obviously going to be important, to give them a solid basis to decide which kind of capital markets transaction to pursue.

I’ve done my share lately of cursing the darkness in this blog, remonstrating against the advisors, lawyers and bankers who’ve grown rich off promoting OTCBB and Pink Sheet listings, reverse mergers and SPAC deals. It’s time I also lit a candle.

Together with my colleagues at China First Capital, we’ve been working on a Chinese-language publication called “如何选择上市的时机和地点” or “When and Where to IPO”. It discusses at some length the problems with listing on OTCBB, or doing other kinds of rushed IPOs.

We’ll be completing it this week, and once done, we’ll do our utmost to make it as widely available as possible, in print and online.

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Market capitalization plays a very important part in the success and stability of a Chinese SME’s shares after IPO. In general, the higher the market capitalization, the less volatility, the more liquidity. All are important if the shares are to perform well for investors after IPO.

There is no simple rule for all companies. But, broadly speaking, especially for a successful IPO in the US or Hong Kong, market capitalization at IPO should be at least $250 million. That will require profits, in the previous year, of around $15mn or more, based on the sort of multiples that usually prevail at IPO.

Companies with smaller market capitalizations at IPO often have a number of problems. Many of the larger institutional investors (like banks, insurance companies, asset management companies) are prohibited to buy shares in companies with smaller market capitalizations. This means there are fewer buyers for the shares, and in any market, whether it’s stock market or the market for apples, the more potential buyers you have, the higher the price will likely climb.

Another problem: many stock markets have minimum market capitalizations in order to stay listed on the exchange. So, for example, if a company IPOs on AMEX market in the US with $5mn in last year’s profits, it will probably qualify for AMEX’s minimum market capitalization of $75 million. But, if the shares begin to fall after IPO, the market capitalization will go below the minimum and AMEX will “de-list” the company, and shares will stop trading, or end up on the OTCBB or Pink Sheets. Once this happens, it can be very hard for a company’s share price to ever recover.

In general, the stock markets that accept companies with lower profits and lower market capitalizations, are either stock markets that specialize in small-cap companies (like Hong Kong’s GEM market, or the new second market in Shenzhen), or stock markets with lower liquidity, like OTCBB or London AIM.

Occasionally, there are companies that IPO with relatively low market capitalization of around RMB300,000,000 and then after IPO grow fast enough to qualify to move to a larger stock market, like NASDAQ or NYSE. But, this doesn’t happen often. Most low market capitalization companies stay low market capitalization companies forever.

Another consideration in choosing where to IPO is “lock up” rules. These are the regulations that determine how long company “insiders”, including the SME ownerand his family, must wait before they can sell their shares after IPO. Often, the lock up can be one year or more.

This can lead to a particularly damaging situation. At the IPO, many investment advisors sell their shares on the first day, because they are often not controlled by a lock up and aren’t concerned with the long-term, post-IPO success of the SME client.  They head for the exit at the first opportunity.

These sales send a bad signal to other investors: “if the company’s own investment advisors don’t want to own the shares, why should we?” The closer it gets to this time when the lock up ends, the further the share price falls. This is because other investors anticipate the insiders will sell their shares as soon as it becomes possible to do so.

There are examples of SME bosses who on day of IPO owned shares in their company worth on paper over $50 million, at the IPO price. But, by the time the lock up ends, a year later, those same shares are worth less than $5mn. If it’s a company with a lot market capitalization, there is probably very little liquidity. So, even when the SME bosshas the chance to sell, there are no buyers except for small quantities.

The smaller the market capitalization at IPO, the more risky the lock-in is for the SME boss. It’s one more reason why it’s so important to IPO at the right time. The higher an SME’s profits, the higher the price it gets for its shares at IPO. The more money it raises from the IPO, the easier it is to increase profits after IPO and keep the share price above the IPO level.   This way, even when the lock up ends, the SME boss can personally benefit when he sells his shares.

Of all the reasons to IPO, this one is often overlooked: the SME boss should earn enough from the sale of his shares to diversify his wealth. Usually, an SME boss has all his wealth tied up in his company. That’s not healthy for either the boss or his shareholders. Done right, the SME boss can sell a moderate portion of his shares after lock in, without impacting the share price, and so often for the first time, put a  decent chunk of change in his own bank account.

We give this aspect lot of thought in planning the right time and place for an SME’s IPO. We want our clients’ owners and managers to do well, and have some liquid wealth. Too often up to now, the entrepreneurs who build successful Chinese SMEs do not benefit financially to anything like the extent of the cabal of advisors who push them towards IPO. 

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The timing of IPO is the most important question for all Chinese SME preparing for a public listing. Unfortunately, the correct answer is often the one most rarely heard. Instead, many investment bankers and advisors in China tell the SME boss that an IPO should be scheduled “as soon as possible”.

This is often music to the bosses untrained ears, since they’re wrongly assuming that the proceeds of an IPO will go directly into their pockets – a misconception these same investment bankers and advisors can literally cash in on. They’ll tell the SME boss the “bad” news — that the IPO proceeds must go to the company not to his personal bank account, and that the boss won’t be able to sell any of his own shares for a year or more after the IPO – towards the end of the expensive pre-IPO planning process, when it’s usually too late to pull out, without losing a huge amount of money.

This is if they bother to mention it at all. I’ve heard of instances where the Chinese boss is never told directly by his investment bankers, lawyers and advisors, but only finds out if his staff prepares a Chinese translation of the SB-2 prospectus used in OTCBB listings.

So, if not “right away”, what is the correct answer to the question: “when should a Chinese SME IPO”? Of course, circumstances will differ for each company. But, as a general principle, an IPO should come at the apex of an SME’s growth curve, when the company is achieving its historical highest return on equity and return on investment. This way, the SME will get a fuller value for its shares when it does list them publicly.

This also explains why pre-IPO private equity can have such a key role to play in the process. The purpose: put more capital to work than the company can generate internally, or can borrow from banks. This equity capital is then invested where it will earn the highest return over a two to three year period – for example, increasing production and improving economies of scale, or accelerating the pace of opening new distribution outlets.

The PE firm will also help improve efficiencies – in their role as risk-sharing partner with the SME boss – that can lead to significant improvement in net margins. In most cases, the pre-IPO PE capital can result in a doubling of profits. Done right, the pre-IPO capital will result in only modest level of dilution for existing owners – usually no more than 25%. It’s like switching on the after-burners: the SME can speed up its growth, improve its margins, seize large available market opportunities, and so position itself for a far more successful IPO in two to three years’ time.

An IPO has one great value above everything else: it will be the cheapest and most efficient way for an SME to raise the capital it needs to expand its business. The shares will likely be valued at multiples two times higher than a pre-IPO PE investor will pay. Since the amount of capital raised will be a multiple of profits, the higher the profits at IPO the better.

To illustrate this, let’s imagine a company with profits last year of RMB75 million. It has its IPO now, at a PE of 15 and its market capitalization at IPO is RMB 1,125,000,000. The company sells 25% of its shares in the IPO, and so it raises RMB 281,250,000. If instead the company waits another year, it raises a RMB50 million of pre-IPO private equity to help push its profit growth. A year later, profits have reached RMB120 million. If the company now has its IPO, at the same PE of 15, and sells 25% of the shares, it will raise RMB450,000,000 or 60% more.

Let’s  assume  the company continues to maintain a high return-on-investment, after IPO. If so, the more money raised at IPO, the higher profits should be able grow in the future. This is perhaps the most important predictor of overall share performance after IPO. By waiting to IPO, so that its size and profits would be larger, this company will be able to raise much more at IPO and so continue generate higher profits for many years into the future.

A company can IPO only once. So, it is important to raise the optimal amount during this one IPO. If a company IPOs too early, it will sacrifice its ability to finance its growth in the future. Many of the most successful IPOs in China were for private SME companies that had pre-IPO investment from private equity companies: Baidu, Alibaba, Suntech, Belle. That isn’t a coincidence. It’s the result of the sort of smart IPO-planning that is too rare in China.

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My last two posts have elicited an unusual amount of feedback. The posts deal with the underhandedness, deceit, negligence and shameless greed of so many of the advisors, lawyers and investment bankers doing IPOs of Chinese companies outside China. 

It’s always nice to get mail. Well, mostly. A lot of the comments and emails were complimentary. But, probably half of the email traffic came from various ethically-challenged financial advisors, brokers, lawyers and fixers asking to work with me on their different China IPO schemes. All of them were, from what I could tell, the sort of transactions I railed against in my recent posts – particularly OTCBB listings, reverse mergers. In other words, the same people I would like to see neutered wrote to see if I wanted to go whoring around with them. 

I even got invited to a reverse merger conference in Las Vegas — hard to decide which part I’d least prefer, the conference or the setting.

In one sense, this is more than a little depressing. Either these guys hadn’t understood what I wrote, or figured I would be a useful shill for them somehow: “Look, we even convinced that guy Fuhrman who criticized OTCBB listings to get in on the game.” If so, they seriously miscalculated. 

There is another, more hopeful explanation for these wildly off-target emails. I know that times have gotten very tough for this whole crowd who made all the money wrecking what were often quite promising Chinese SME companies by convincing them to do bad IPO deals. The stock market, of course, is still limping, and most IPO activity (both the good and the debased) has all but dried up. 

Perhaps, then,  these emails to me are a last dying gasp, a tangible sign that the low practices that flourished over the last ten years are doomed. That would be great news, that bad advisors are contacting me as a last resort, because they’ve tried everything else and failed to revive a once-lucrative franchise fleecing good Chinese companies. 

You know what they say about things that sound too good to be true… We’ll see. 

For the record, as well as for those who may harbor any lingering hope I might be able to revive their business doing OTCBB listings or reverse mergers, I wanted to set out, clearly, what it is we do:

Now, I can imagine what a few of my recent email correspondents must be thinking, “What a dope. Why would anyone bother with this ‘high integrity’ stuff when you can make a fortune pushing Chinese companies through the IPO meat grinder?” 

That sort of approach, of grabbing fees while mutilating your client,  is so far removed from what I built China First Capital to do that it’s like asking a ballerina to enter a demolition derby. I’m lucky (or crazy, take your pick), but I didn’t start CFC with the primary motive of making money. I started it for three reasons:

(1) to have a chance, after achieving some career success elsewhere, to give something back to China, a country that’s been the deep and abiding love of mine since I was a little boy;  (2) to work alongside world-class founder/entrepreneurs, and help them get the financing they need to go farther and faster, and so become industry leaders in China over the next 10-20 years; and (3) to provide Chinese SMEs with at least one alternative to the sort of noxious advisory firms that have preyed on them for over 10 years. 

It’s demanding work. We refuse to cut corners, or get involved with a deal because there’s easy money to be made. We view our clients as our partners, not as a meal ticket.  In all these ways, I know I come from a different planet than the guys who arrange OTCBB deals, reverse mergers, or other quickie IPOs.

There’s another difference: I feel profoundly lucky every day to do what I get to do. I doubt they do. 

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My last post dealt with the often-unprincipled conduct of the advisors, bankers and lawyers who created many of the disaster stories among Chinese SME companies seeking a stock-market listing. It’s not a topic that will win me a lot of friends and admirers among the many advisors, lawyers, and investment banker-types still active, sadly, sponsoring OTCBB and reverse merger deals in China. In my experience, they tend to put the blame elsewhere, most often on Chinese bosses who (in their view) were blinded by the prospect of quick riches and so readily agreed to these often-horrible transactions. 

There’s some truth to this, of course. But, it’s a little like a burglar blaming his victim for leaving a second-story window unlocked. Culpability – legal and moral – rests with those who are profiting most from these bad IPO deals. That’s the advisers, bankers and lawyers.  They are the ones getting rich on these deals that, too often, leave the Chinese company broken beyond repair. 

The bad IPO deals are numerous, and depressingly similar. I don’t make any effort to keep tabs on this activity. I usually only learn specifics if I happen to meet a Chinese SME boss who has had his company crippled by doing an OTCBB listing or reverse merger, or an SME that is in the process of doing a deal like this. 

Here are a few “case studies” from among the companies I’ve met. They make for depressing reading. I’m omitting the names of the companies and their advisers.  The investment bankers on these deals deserve to be publicly shamed (if not flogged) for what they’ve done. But, the stories here are typical of  many more involving crooked investment bankers and advisers working with Chinese SME. The story lines are sadly, very familiar. 

COMPANY 1

A Guangdong electrical appliance company, with 1,500 employees, had 2008 revenues of $52mn, and net profit of $4mn, did a “reverse merger” in 2007 and then listed its shares on the OTCBB. Despite the company’s good performance (revenues and profits grew following the IPO), the share price fell by 90% from $4.75 to under 5 cents. At the IPO, the “investment advisors” sold their shares. The company also raised some cash, about $8mn in all.  But, quickly, the share price started to fall, and the market capitalization fell from high of $300mn to under $4mn. The company’s management didn’t have a clue how to manage a US publicly-traded company (none spoke English, for one thing), and so started making regulatory mistakes and had other problems with filing SEC documents. The company’s management, still with much of the $8mn raised in the IPO in its corporate bank account,  then started selling personal assets at wildly inflated prices to the company, and so used these related party transactions to take most of the remaining cash from the business into their pockets. No surprise, the company’s auditors discovered problems during its annual SEC audit, and then resigned.

The company’s share price is so low it triggered the “penny stock” rules in the US, which limit the number of investors who are allowed to buy the shares.

COMPANY 2

An agricultural products company with $73 million in 2008 revenues chose to do a “reverse merger” in the US, to complete a fast IPO early in 2009. The company got the idea for this reverse merge from an investment adviser in China who promised to raise $10 million of new capital as part of the reverse merger. The agricultural products company believed the promise, and spent over $1 million to buy the listed US shell company, including high fees to US lawyers, accountants and advisers.   

After buying the shell and spending the money, the company learned that the advisor had failed to raise any new capital. The company now has the worst possible situation: a listing on the OTCBB, with no new capital to expand its business, a steadily falling share price, and annual costs of being listed on the OTCBB of over $500,000 a year. At this point, no new investor is likely to invest in the company, because it already has a public listing, and a very low share price.

Because of this reverse merger, the company’s financial situation is now much worse than it was in 2008, and the company’s founder effectively now has no options to finance the expansion of his business which, up until the time of this reverse merger, was thriving.

 COMPANY 3

In 2008, an outstanding Guangdong SME manufacturing company signed an agreement with a Guangdong  “investment advisor” and a small US securities company that specializes in doing “Form 10 Listings” of Chinese SME on the OTCBB. They told the company’s boss they were a “Private Equity firm”. The investment advisor and the US securities company were working in concert to take as much money from this company as possible. Their contract with the company gave them payments of over $1.5 million in cash for raising $6mn for the company, a fee of 17%, and warrants equal to over 20% of the company’s shares. The $6mn would come from the securities company itself, so it could claw back a decent chunk of that in capital-raising fees, and also grab a huge slug of the equity through warrants. 

The securities company quickly scheduled a “Form 10” IPO for summer of 2008, and arranged it so the shares to be sold would be the warrants owned by this securities company and the Chinese investment advisor. So, according to this scheme, the Chinese SME would have received no money from the IPO, and all the money (approximately $10 million) would have gone direct to the securities company and the advisor.

The securities company deliberately misled the SME founder into thinking his shares would IPO on NASDAQ. Further, they gave the founder false information about the post-IPO performance of the other Chinese SME they had listed through “Form 10 Listings” on the OTCBB. Most had immediately tanked after IPO. 

In this case, the worst did not happen. I had met the boss a few months earlier, through a local bank in Shenzhen, and liked him immediately.  Before the IPO process got underway, I offered him my help to get out of this potentially terrible transaction. This was before I’d set up China First Capital, so the offer really was one of friendship, not to earn a buck. I promised him if he could get out of the IPO plan, I’d raise him money at a much higher valuation from one of the best PE firms in China. 

The boss was able to cancel the IPO plan, and I started China First Capital with the first goal of fulfilling my promise to this boss.  CFC quickly raised the company $10mn in private equity from one of the top PE companies , and the valuation was over twice the planned IPO valuation from the “investment advisor” and the securities company. This SME used the $10mn in pre-IPO capital to build a new factory to fill customer orders. 2009 profits will double from 2008. The company is on path to an IPO in 2011, and at that time, the valuation of the company will likely be over $300mn, +7X higher than at the time of PE investment.

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Back again in Shenzhen, with plenty of food for thought, as well as food for the belly. I go through the same “immersion program” whenever I arrive back here: it involves stopping for a plate of dumplings or bowl of noodles once every 30 paces. Or anyway, it certainly seems that way. 

The food for thought, as always, centers on ways to deliver enhanced value and service to clients and business partners. We have a set of core principles, that we build our business on, and that collectively represent our main differentiators. They are disarmingly simple – to work with integrity and honesty,  and always put the success of our clients’ first. We know that if we do this, our own success will follow. 

Simple, but not nearly as universal as they should be in our business. A lot of investment banking, IPO and advisory work in China has bordered on the criminal. Hundreds of SME companies were damaged, if not destroyed, by advisors, lawyers and others who neglected entirely to put their clients’ interests first. Instead, they pushed for companies to take various fast routes to IPO in the US, typically reverse mergers, OTCBB Listings, Form 10, SPAC deals. The reason: the advisors, lawyers, bankers all made a pile of money, quickly, through these kinds of deals. When things turned sour, as they often did, the advisers, bankers and lawyers were generally nowhere to be found, and the Chinese companies were left in dire straits.

Obviously, the bosses of the Chinese companies were complicit, since they agreed to these kinds of schemes to achieve a fast IPO. But, in my experience, the bosses main sin was that of ignorance. They simply didn’t understand all the workings of these kinds of deals, or even the fee-structure that would disproportionately reward the advisers, lawyers and bankers. In other words, the Chinese bosses didn’t do their DD, didn’t check the dismal track record of the many Chinese companies that already opted for OTCBB listings or reverse mergers.

I sometimes think the Chinese term for IPO, “上市” ( “shang shi”) has magical, intoxicating effect on some Chinese bosses. They hear it and suspend all their normal caution and suspicion. Soon, they end up agreeing to what are often truly disastrous transactions that don’t even deserve the name IPO.

There are, by some estimates, several hundred Chinese companies now listed on the OTCBB that are somewhere between “on life support” and “clinically dead”. Their share prices fell steeply immediately after listing (by which time the advisers, bankers and lawyers all pocketed their fees and lined up their next victims) and are below $1. There is little to no liquidity. They often trade at PE multiples of 1-2x. The costs of retaining the OTCBB listing are bleeding the companies of badly-needed money. They have no chance to raise additional capital, nor to do much of anything (except waste money on Investor Relations firms) to lift their share price.

I get angry just thinking about this. I’m offended that people in my field of work would be involved in such self-serving, greed-ridden transactions. Secondly, it’s also brought a lot of harm, and sometimes complete failure, to what were very good Chinese SME companies that once had bright futures, until they had the misfortune of putting their financial futures in the hands of these advisors.

Of course, the guiding principle behind all investment decisions must be “caveat emptor”. Chinese bosses clearly didn’t “caveat” enough. That’s regrettable. But, the gains made by the advisors, lawyers and bankers were so enormous, and so ill-gotten. That’s the heart of the matter: Chinese companies were ruined so that a bunch of ethically-challenged finance people could get rich.  For me, this is contemptible.  How these people sleep at night I don’t know.

I do know this: we try to do everything we can to make it less likely that a good Chinese SME goes the same route, and ends up in the same sad condition. One way is through information. We’re producing Chinese-language materials meant to explain the hazards of transactions like OTCBB listings and reverse mergers. Our plan is to distribute the materials as widely as possible, both online and off. It may not put the bad guys out of business, but at least it will make it easier for Chinese SME bosses to know which questions to ask, what kind of track record to look for or, more often,  run away from.

I’ll be sharing soon on this blog  the English version of some of this information.

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China First Capital (CFC) this week announced that we’ve established a strategic partnership with Horwath Capital China (HCC), part of Crowe Horwath, one of the ten-largest international accounting firms. HCC is led by David Yu, a very impressive individual and fast becoming a good friend. David qualified both as a lawyer and a CPA, and has built HCC into a powerful financial services firm, based in Beijing, and focused largely on providing China’s SME businesses with accounting, legal and other strategic advisory services.

• You can read about the partnership here, in English: (http://finance.yahoo.com/news/Horwath-Capital-China-and-prnews-15131234.html?.v=2  )
• And here in Chinese: (http://www.prnasia.com/pr/09/05/09263221-2.html  ).

I wanted to spell out more of what lies behind this partnership – why we’re doing it, the strategic intent, the scale of the opportunity, and the ambitious goals we hope it will achieve. Through the partnership, our aim is to raise the level of financial services available to China’s best SMEs, to meet their specific needs. That’s a tall order, and we’re cognizant of the challenges. It’s now down to both companies to make this a reality.   

HCC are an optimal partner for China First Capital, and so we’re genuinely pleased and honored to be working with them. CFC and HCC both share that same focus on Chinese SMEs, and for the same good reason: both firms see that many of China’s best SMEs will emerge over the coming years as some of China’s most successful and dominant private companies. They won’t be “Small or Medium” for long.  

While China’s largest and most internationally-known companies tend to be partly state-owned (China Mobile, CNOOC, Sinopec), the private sector is where China’s economic future resides. By some estimates, over 70% of China’s GDP is generated by private companies. Twenty years ago, the percentage was less than 10%. That’s a remarkable transformation, unparalleled in modern economic history. Another key differentiator: China’s economy has privatized without privatization. In other words, this shift from state-owned to privately-owned economy happened not primarily because state firms were privatized. That’s the route taken in Europe, most famously in the UK, where during the 1980s, Margaret Thatcher sold to private investors previously nationalized companies like British Petroleum, British Telecom, British Gas.  

In China, privatization has played a very minor role in lowering the government’s share of GDP. Instead, China created legal and economic circumstances where private companies could form, compete and prosper.   And prosper they have. With few exceptions, the best and fastest-growing companies in China are now private ones, the SMEs that China First Capital and Horwath both work with. These SMEs are still smaller in scale than the state-owned giants. But, that will change.  

The strategic rationale behind our partnership with Horwath is to “change the game” in corporate finance and advisory services in China. The partnership’s explicit goal is to be the first in China to deliver to these strong SMEs the highest international standards of corporate financial advisory work. Together, we offer SMEs a complete platform including capital-raising, audit and M&A advisory, to assist in their continued growth, and eventual IPO listing on public stock markets.  

No other firm can offer this range of services to SMEs, at a uniformly high international level. The big investment banks and accounting firms charge too much, and generally won’t work with smaller firms. Domestic firms tend to be weak in areas such as private equity capital-raising and implementing international accounting standards that structure a Chinese company for a successful IPO.  

Just as important is what we won’t do. We won’t push a Chinese SME to go public before the right moment; we won’t put earning fees ahead of the best interests of the client. Sadly, in China, there are many, many precedents of unscrupulous or unprofessional “investment advisors” who have damaged or destroyed Chinese SMEs by pushing them to IPO too early, on the wrong market (example, the US Over-the-Counter Bulletin Board) or via an ill-structured “reverse merger”. The advisors make millions, and the SMEs never recover. 

Both David Yu and I share a similar purpose here: we think these great Chinese SMEs should have access to financial advisory services that are of a similarly high caliber to what larger companies now use.  We are not chasing fees. If so, we’d go after larger companies. We both see an opportunity to work with some outstanding SMEs that are on the verge of becoming industry leaders. If we do our part with this partnership between CFC and HCC, the SMEs reach that next level of success more quickly and efficiently than they would otherwise.

That’s the measure of success for us — not that CFC and HCC will increase their own fee income. If that happens, it should only be a result of the one thing that really matters to us: that our SME clients grow faster and stronger than their peers. 

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