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.  

Two truisms about China should carry the disclaimer “except in Xinjiang”. China is a densely-populated country, except in Xinjiang. China is short on natural resources, except in Xinjiang. Representing over 15% of the China’s land mass, but with a population of just 30 million, or 0.2% of the total, Xinjiang stretches 1,000 miles across northwestern China, engulfing not only much of the Gobi Desert, but some of China’s most arable farmland as well. Mainly an arid plateau, Xinjiang is in places as green and fertile as Southern England.

Underneath much of that land, we are beginning to learn, lies some of the world’s largest and richest natural resource deposits, including huge quantities of minerals China is otherwise desperately short of, including high-calorie and clean-burning coal, copper, iron ore, petroleum.  How, when and at what cost China exploits Xinjiang’s natural resources will be among the deciding issues for China’s economy over the next thirty years. Already, some remarkable progress is being made, based on two past visits. I return to Xinjiang tomorrow for five days of client meetings.

Because of its vast size and small population, Xinjiang hasn’t yet had its mineral resources fully probed and mapped. But, every year, the size of its proven resource base expands. Knowing there’s wealth under the ground, and finding a cost-effective way to dig out the minerals and get them to market are, of course,  very different things. Until recently, Xinjiang’s transport infrastructure – roads and railways – was far from adequate to provide a cost-efficient route to market for all the mineral wealth.

That bottleneck is being tackled, with new expressways opening every year, and plans underway to expand dramatically the rail network. But, transport can’t alter the fact Xinjiang is still very remote from the populated core of China’s fast-growing industrial and consumer economy. Example:  it can still be cheaper to ship a ton of iron ore from Australia to Shanghai than from areas in Xinjiang.

Xinjiang’s key resource, and the one with the largest potential market, is high-grade clean-burning coal. Xinjiang is loaded with the stuff, with over 2 trillion tons of proven reserves. Let that figure sink in. It’s the equivalent of over 650 years of current coal consumption in coal-dependent China . The Chinese planners’ goal is for Xinjiang to supply about 25% of China’s coal demand within ten years.

Xinjiang’s coal is generally both cleaner (low sulphur content) and cheaper to mine than the coal China now mainly relies on, much of which comes from a belt of deep coal running through Inner Mongolia, Shanxi and Shandong Provinces. Large coal seams in Xinjiang can be surface mined. Production costs of under Rmb150 a ton are common. The current coal price in China is over four times higher for the dirtier, lower-energy stuff.

For all its advantages, Xinjiang coal is not going to become a primary source of energy in China. The Chinese government, rightly, understands that the cost, complexity and long distances involved make shipping vast quantities of Xinjiang coal to Eastern China unworkable. Moving coal east would monopolize Xinjiang’s rail and road network, causing serious distortions in the overall economy.

Instead, the Xinjiang government is doing something both smart and innovative. It is encouraging companies to use Xinjiang’s abundant coal as a feedstock to produce lower cost supplies of industrial products and chemicals now produced using petroleum. All kinds of things become cost-efficient to manufacture when you have access to large supplies of low-cost energy from coal. Shipping finished or intermediate goods is obviously a better use of Xinjiang’s limited transport infrastructure.

I’ve seen and met the bosses of several of these large coal-based private sector projects in Xinjiang. The scale and projected profitability of these projects is awesome. In one case, a private company is using a coal mine it developed to power its $500mn factory to produce the plastic PVC. The coal reserve was provided for free, in return for the company’s agreement to invest and build the large chemical factory next to it. The cost of producing PVC at this plant should be less than one-third that of PVC made using petroleum. China’s PVC market, as well as imports, are both staggeringly large. The new plant will not only lower the cost of PVC in China but reduce China’s demand for petroleum and its byproducts.

Another company, one of the largest private companies in China,  is using its Xinjiang coal reserve, again supplied for free in return for investment in new factories, to power a large chemical plant to produce glycerine and other chemical intermediates. This company is already a large producer of these chemicals at its factories in Shandong. There, they run on petroleum. In the new Xinjiang facility, coal will be used instead, lowering overall manufacturing costs by at least 20% – 30% based on an oil price of around $50. At current oil prices, the cost savings, and margins, become far richer.

The key, of course, is that the companies get the coal reserve for free, or close to it. True, they need to build the coal mine first, but generally, that isn’t a large expense, since it can all be surface-mined.  This means that the cost of energy in these very energy-intensive projects is much lower than it would be for plants using petroleum or, to be fair, any operator elsewhere who would need to purchase the coal reserve as well as build the capital-intensive downstream facilities.

The Xinjiang projects should lock-in a significant cost advantage over a significant period of time. As investments, they also should provide consistently high returns over the long-term. While the capital investment is large, I’m confident the projects are attractive on risk/return basis, and that in a few years time, these private sector “coal-for-petroleum” projects will begin to go public, and become large and successful public companies.

The Xinjiang government keeps close tabs on this process of providing free coal reserves for use as a feedstock.  Since in most cases, these projects are looking to enter large markets now dominated by petroleum and its byproducts, there is ample room for more such deals to be done in Xinjiang.

Deals are getting larger. This summer, China’s largest coal producer, Shenhua Group, announced it would invest Rmb 52 billion ($8 billion) on a coal-to-oil project in Xinjiang. The company plans to mine 70 million tons of coal a year and turn it into three million tons of fuel oil.

Remote and sparsely-populated as it now is, Xinjiang is going to play a decisive role in China’s industrial and energy future, just as the development of America’s West has helped drive economic growth for over 100 years, and created some of America’s largest fortunes.  My prediction:  China’s West will produce more coal and mineral billionaires over the next 100 years than America’s has over the past hundred.

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True of false? The basis of China’s global economic competitiveness is cheap labor? False. It’s cheap factory land.

No doubt,  until a few years ago, China’s low labor costs were a vital part of its economic growth story. That is no longer the case. Labor costs have risen sharply in the last five years. There are now many countries with a decided labor cost advantage over China. And yet China remains the “factory of the world”. For one thing, its workers have higher productivity than those earning lower wages in countries like Vietnam, India or Indonesia.

But, there is a more fundamental, and most often overlooked, reason for China’s global economic competitiveness. Factories, and other productive assets like mines or logistics centers, are built on land that is either free of close to it. The result is that in China land costs usually represent an inconsequential component of overall manufacturing and operating costs. This, in turn, gives China an inbuilt edge and, when added to the productivity of its workers, an insurmountable cost advantage over the rest of the world.

There is no good international data on the percentage of a company’s fixed costs that come from purchase or rental of land. But, it is certainly the case that in China, this percentage will be far lower than in any developed – and many developing – countries. This isn’t because land is cheap in China. It isn’t. The market price, in most areas, is often on par with land costs in the US. But, good businesses in China don’t pay market price. Often they pay nothing at all.

This has two useful aspects for the favored Chinese business. First, it means the cost of expanding operations is limited primarily to the cost of new capital equipment and factory construction. Second, the business given a plot of land is thus endowed with a valuable asset it can use as collateral to secure more funding from banks. Even better, if the business runs into trouble or later goes bust, the owner will be able to sell the land at market price and pocket a huge personal gain.

It can’t be overstated just how important this is to a business owner’s calculation of risk, and so the success of Chinese entrepreneurial companies. Owners know that if all goes bad, they still hold land acquired for little or nothing for that is worth millions of dollars.

All land in China belongs to the Chinese government. Every year, a fraction of it is released on a long-term lease (usually forty years or longer) for development into commercial or residential land. While there is no official central policy to make land available at low prices to successful businesses, in practice, this is the way the system works. Land is sold at deeply-discounted prices, or given outright, to businesses that are seeking to expand, often by building a new factory or office building.

Land in China, it goes without saying, is in very high demand. It’s a crowded country, and only 15% of the land is flat or fertile enough to be suitable for cultivation. This “good land” is also where most new factories get built.

There isn’t enough new land released every year to meet the enormous demand. This is true both for residential land, a key reason why housing prices are so high, and commercial land. For most businessmen, it’s impossible to get new land, at any price. A privileged group, however, not only gets land to expand, but gets it at artificially low prices. In China, land prices are elastic. Different levels of government have ways to transfer land to companies at prices equal to 5%-15% of its current market value.

Officially, the land allocation system in China is meant to work in a more market-oriented way, with new land for development being auctioned publicly, and selling prices controlled and verified by higher levels of government. In other words, the system is meant to discourage, if not prohibit, land being given to insiders at low prices. In practice, these rules are often more observed in the breach. Local governments have ways to control the outcome of land auctions and so guarantee that favored businesses get the land they want at attractive prices.

These below-market sales deprive the local government of revenue it might otherwise earn from a land deal done at closer to market prices. But, there is some economic logic at work. The sweetest of sweetheart land deals are generally offered to successful companies whose growth is being stifled by insufficient factory space. The new land, and the new factories that will be built there, will increase local employment and, down the road, tax revenues.

Note, the deeply-discounted land prices are available mainly to companies that are already successful, and straining at the leash to maintain growth and profits. Both private and state-owned companies are eligible. It’s a rare example of even-handed treatment by officials of state-owned and private companies.

Is corruption also a factor? Are cheap land deals really not all that cheap when various under-the-table payments are factored in? My personal experience, though limited, suggests such payoffs, if they happen,  are not compulsory.

I’ve played a walk-on part in several below-market land deals. My role is to meet with local officials, usually the mayor or party secretary,  to urge them to provide my client with the land needed for expansion. All local government officials in China are also motivated by, and rewarded for, having local companies go public. I stick to that point in my discussions with the local officials – my client needs land to grow and so reach the scale where the business can IPO.

In each case, the deal has gone forward, and clients have gotten the land they were seeking, at a price 5-15% of its then-market value. My client wins the trifecta: the business grows larger, unit costs remain low because of scale economies and the cheap land, and the balance sheet is strengthened by a valuable asset purchased on the cheap.

In all respects, this system of commercial land acquisition is unique to China. It is also a key component in the country’s economic policy, though it never has been proclaimed as such. The government at all levels is keen to keep GDP growing smartly. This process of rewarding good companies with cheap land for growth plays a key part in this, everywhere across China. China’s government (at national, provincial and local levels) is not hurting for cash, unlike for example America’s. Tax revenues are growing by upwards of 30% a year. So, maximizing the value of land released for development is not a fiscal priority.

Who loses? There are likely incidences where peasants are thrown off land with little or no compensation to make way for new commercial district. But, that way of doing things is becoming less common in China.

Mainly, of course, the losers are the international competitors of Chinese companies getting cheap land to expand. It’s hard enough to stay in business these days when facing competition from China. It verges on hopeless when the Chinese companies can build output and lower unit prices because of land they get for free or close to it.

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Among major cities in China, Chengdu takes the prize as most pleasant, livable,  comfortably affluent, relaxed and charming. I arrived back here today. I’m reminded immediately there’s much to like about Chengdu, and one thing to love: the food.

Chengdu is famed for its “小吃”, (“xiaochi”) literally “small eats”. To translate 小吃 as “snack”, as most dictionaries do, doesn’t even remotely begin to do it justice. A 小吃  is a often one-bowl wonder of intense, jarring flavors. They not only take the place of a full meal with rice, they make the Chinese staple seem almost superfluous, a waste of precious space in the stomach.

There are about a dozen小吃 that can stop me in mid-stride, any time of day. These include several varieties of cold noodles, including the bean jelly ones called 凉粉, literally “cold powder”，as well as dandan noodles served dazzlingly hot, in both senses of the word.

My favorite 小吃 , by a wide margin, is 抄手 , literally, “to fold one’s arms”. It’s an odd name, since the last thing I’d ever do when I see a bowl of抄手 in Chengdu is fold my arms. They are always thrust outward, in anticipation.  抄手 is a bowl of wontons steeped in a fire-engine red soupy sauce, optimally with enough Sichuan pepper corn to numb the tongue all the way down the gullet. This frees up the nose to do the real work of decoding all the subtle flavors.

Offiically, Chengdu has a per capital income of around $5,200, about half Shanghai’s. But, I’d prefer living and working in Chengdu any day. So would many Chinese I know. The economy is doing well, despite some geographic disadvantages. Chengdu is the most westerly of China’s large cities, and so isolated from the most developed regions of China. It’s over 1,000 miles to Shanghai, Beijing, and almost as far to Shenzhen.

Chengdu is doing well economically – though you don’t always have a sense this ranks as high on the list of civic priorities as drinking tea and playing mahjong. The electronics and telecom industries are both doing well. Quite a few companies have received PE investment.

The one industry, however, that is still relatively undeveloped is the food business. This is odd. By logic, Chengdu should be a center of China’s food processing and restaurant industry. Not only is it a great food town, situated in a very region valley producing some of China’s best fruits and vegetables, but it is also capital of Sichuan Province.

Sichuan food is almost certainly the most popular “non native” cuisine across China. Within a mile of where I live in Shenzhen, there are probably over 50 Sichuan restaurants. It’s the same in Beijing, Shanghai and most other major cities.

There’s an innate association in Chinese minds between Sichuan and good food. In this, Sichuan reminds me a lot like Italy. Italian food is prized across all of the Western world, and as a result, some of the Western world’s biggest and most successful food companies are based in Italy. Among the larger ones are Barilla, Bertolli, Buitoni, Parmalat, Ferrero. These, and thousands of smaller ones making wine, cheese, salami, all benefit from the widespread popularity of Italian food, and the high market value of associating a food brand with Italy.

Chengdu and Sichuan should be no different. It should be the capital of China’s food processing industry. But, as far as I can tell, there are as of yet no great food companies or food brands based there.  If you shop around in Chengdu, the food products being marketed as “authentic Sichuan food ” are mainly an assortment of beef jerky, along with sweet and savory biscuits made from beans and peanuts.

There’s nothing wrong with any of these products, but there isn’t a big brand national brand among them. The mass market is going unserved.

Let’s look at two of the biggest food product categories where Sichuan brands should predominate: chili sauce and instant noodles. Each of these product areas have sales of billions of dollars a year in China. Yet, the leading brands come from outside Sichuan. In the case of instant noodles, the leaders are mainly Taiwanese and Japanese.

In chili sauce, the biggest brands all seem to come from Guizhou province. This, particularly, should cause a collective loss of face across Sichuan. Their spicy food  “owns” the palettes of hundreds of millions of people and yet the main brands of chili sauce in supermarkets come from the poorer province to its south.

The companies selling bottled pre-made Sichuan sauces (for popular dishes like Gongbao Jiding, Mapo Toufu and Yuxing Rousi) mainly come from Taiwan, Shanghai, even Hong Kong. It’s as if the most popular brands of spaghetti sauce were made in Brazil. Chinese food companies all over are eating Sichuan’s lunch.

This situation is unnatural and, I’d hope, unsustainable. Sichuan companies should by rights eventually dominate the market for many food products in China, much as Italian food companies are among the largest in Europe.

Some lucky PE investors should someday make a lot of money backing Sichuan food companies. Me and my company would love to play our part in this. Ambitious food entrepreneurs in Chengdu, call us anytime — 0755 33222093. If ever there were a billion-dollar unfilled market opportunity in China, this would be it.

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It’s only a moderate exaggeration to say that everything I’ve learned of value and enduring truth about politics and economics over the last 25 years came from the editorial pages of the Wall Street Journal. For just as long, the one writing goal I’ve held onto was having an op-ed published there. Today’s the day.

“Cease and Desist on Delist-Relist“” is running in today’s Asian edition. I’m delighted. I owe a huge debt of thanks to the Journal’s Joe Sternberg who encouraged me to submit the piece, and then did masterful work shaping and reworking the text from earlier blog posts. 

I’ve known my fair share of editors. When I was at Forbes Magazine many years ago, I had the good fortune to have a fair percentage of my stories edited directly the then Editor-in-Chief, Jim Michaels, who richly deserves the reputation as one of the finest ever in business journalism. He was a maestro. Other Forbes editors? Often klutzes. Joe’s editing work is of Michaels quality. I have no higher standard, or stouter praise.

The full text as published by the Journal is copied below. For anyone who’d like to read the earlier draft, about 15% longer than this version, you can click here.  

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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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Chinese real estate is no longer the easiest legal risk-adjusted money-making business in the world. It’s been a swift reversal. For the better part of twenty years, there’s been no simpler way to amass a great fortune than developing property in China.

The business model was as simple as it was profitable: acquire a piece of property from friends in government at a fraction of its market value, mortgage the property heavily with obliging state-owned banks, sell out most of the units (either offices or apartments) within weeks of construction beginning, and then pocket returns of 500% or more before the building was even occupied.

Continuously rising property prices, often increasing by 10% or more per month,  provided incentive to hold onto some units for later sale. A final wrinkle was to demand a cash advance from the construction company when awarding the building contract, so limiting even more the amount of capital needed, and improving return-on-equity even more.

There was just about zero risk in deals like this. Then, the Chinese government began clamping down, starting gingerly about a year ago and then with added ferocity in recent months,  in an effort to restrain property prices and overall inflation. At this point, what was once the easiest business in China has become one of the hardest. Sweetheart land deals are far more rare, as the central government in Beijing is no longer turning a blind eye.

More importantly, banks have all but stopped lending to property developers. This has dried up liquidity in an industry that was for many years awash in it. The projects getting built now, for the most part, are those where little or no bank debt is required. That means heavy upfront equity investment, or taking money from loan sharks who charge interest rates of 25%-30% a year. This fundamentally alters the arithmetic of a real estate deal in China. The more equity and high-interest debt that goes in, the lower the returns and, it seems,  the more likely a project is to hit problems.

And problems have become the norm. Another government change, little reported but absolutely crucial to the change in fortunes of the real estate business in China, is that it’s no longer easy and cheap to get current residents off the land, so it can be sold at a high price to a developer. New rules make it very expensive and risky for any developer to undertake this process of relocation and demolition.

Any delay, and delays are rampant, can quickly drain away a developer’s cash. For example, if one old tenant refuses to take the relocation money and move out, it is no longer a simple thing in most instances to get the local government, or hired goons, to force them out. Until all old tenants are resettled, no construction can begin. This can push back by months or even years the date that developers can begin pre-sales. Meantime, you keep paying usurious interest rates to lenders who have taken the whole project, as well as many of other unrelated assets, as collateral.

A final nail: residential real estate prices are now rising far more slowly. This is the result of tighter mortgage rules, property taxes in some cities, as well as new regulations that limit the number of apartments people can buy. In Beijing, for example, you need to prove you have paid local Beijing taxes before being allowed to buy.

Of course, taking the easy money out of real estate is a prime policy objective of the Chinese government. That the government would be successful in this was never much in doubt. The speed and geographical scope of the impact, however, has caught a lot of people (including me) by surprise. Projects that six months ago looked like sure things are today struggling. The sudden evaporation of bank finance, in particular, is playing havoc. Banks in China are state-controlled. When they responded slowly, earlier this year, to government suggestions they slow the flow of funds to the real estate sector, the government took more active measures, including raising six times banks’ reserve requirements.

Rocketing property prices are a major contributor, directly and indirectly, to inflation, which is now, by official figures, at its highest level in China in over three years. So, the government’s actions had a broader purpose than altering the return formula for real estate investment in China. At the moment, though, that’s been the main impact, to make it far harder to do both residential and commercial real estate projects in China. When and by how much inflation will be curbed is unclear.

The bigger question is: has the game changed permanently in Chinese real estate, or will things revert as soon as inflation is down to where the government wants it to be. The rising real estate prices of the last 20 years have not only helped the country’s real estate barons. They have also been a main source of rising middle class wealth in China. That’s where the government policy becomes more an art than science: how to strip away real estate developers’ easy profits, while keeping the middle class feeling flush and contented. I’ll write about that in a following blog post.

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Hands down, it is the worst investment idea in the private equity industry today: to buy all shares of a Chinese company trading in the US stock market, take it private, and then try to re-list the company in China. Several such deals have already been hatched, including one by Bain Capital that’s now in the early stages, the planned buyout of NASDAQ-quoted Harbin Electric (with PE financing provided by Abax Capital) and a takeover completed by Chinese conglomerate Fosun.

From what I can gather, quite a few other PE firms are now actively looking at similar transactions. While the superficial appeal of such deals is clear, the risks are enormous, unmanageable and have the potential to mortally would any PE firm reckless enough to try.

A bad investment idea often starts from some simple math. In this case, it’s the fact there are several hundred Chinese companies quoted in the US on the OTCBB or AMEX with stunningly low valuations, often just three to four times their earnings.  That means an investor can buy all the traded shares at a low overall price, and then, in partnership with the controlling shareholders,  move the company to a more friendly stock market, where valuations of companies of a similar size trade at 20-30 times profits.

Sounds easy, doesn’t it? It’s anything but. Start with the fact that those low valuations in the US may not only be the result of unappreciative or uncomprehending American investors. Any Chinese company foolish enough to list on the OTCBB, or do any other sort of reverse merger, is probably suffering other less obvious afflictions. One certainty:  that the boss had little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing which, among its other curses, likely cost the Chinese company at least one million dollars to complete, including subsequent listing and compliance costs.

Why would any PE firm, investing as a fiduciary, want to go in business with a boss like this? An “undervalued asset” in the control of a guy misguided enough to go public on the OTCBB may not be in any way undervalued.

Next, the complexities of taking a company private in the US. There’s no fixed price. But, it’s not a simple matter of tendering for the shares at a price high enough to induce shareholders to sell. The legal burden, and so legal costs, are fearsome. Worse, lots can – and often will – go wrong, in ways that no PE firm can predict or control. The most obvious one here is that the PE firm, along with the Chinese company, get targeted by a class action lawsuit.

These are common enough in any kind of M&A deal in the US. When the deal involves a cash-rich PE firm and a Chinese company with questionable management abilities, it becomes a high likelihood event. Contingency law-firms will be salivating. They know the PE firm has the cash to pay a rich settlement, even if the Chinese company is a total dog. Legal fees to defend a class action lawsuit can run into tens of millions of dollars. Settling costs less, but targets you for other opportunistic lawsuits that keep the legal bills piling up.

The PE firm itself ends up spending more time in court in the US than investing in China. I doubt this is the preferred career path for the partners of these PE firms. Bain Capital may be able to scare off or fight off the tort lawyers. But, other PE firms, without Bain’s experience, capital and in-house lawyers in the US, will not be so fortunate. Instead, think lambs to slaughter.

Also waiting to explode, the possibility of an SEC investigation，or maybe jail time. Will the PE firm really be able to control the Chinese company’s boss from tipping off friends, who then begin insider trading? The whole process of “bringing private” requires the PE firm to conspire together, in secret, with the boss of the US-quoted Chinese company to tender for shares later at a premium to current price. That boss, almost certainly a Chinese citizen, can work out pretty quickly that even if he breaks SEC insider trading rules, by talking up the deal before it’s publicly disclosed, there’s no risk of him being extradited to the US. In other words, lucrative crime without punishment.

The PE firm’s partners, on the other hand, are not likely immune. Some will likely be US passport or Green Card holders. Or, as likely, they have raised money from US institutions. In either case, they will have a much harder time evading the long arm of US justice. Even if they do, the publicity will likely render them  “persona non grata” in the US, and so unable to raise additional funds there.

Such LP risk – that the PE firm will be so disgraced by the transaction with the US-quoted Chinese company that they’ll be unable in the future to raise funds in the US – is both large and uncontrollable. The potential returns for doing these “delist-relist” deals  aren’t anywhere close to commensurate with that risk. Leaving aside the likelihood of expensive lawsuits or SEC action, there is a fundamental flaw in these plans.

It is far from certain that these Chinese companies, once taken private, will be able to relist in China. Without this “exit”, the economics of the deal are, at best, weak. Yes, the Chinese company can promise the PE firm to buy back their shares if there is no successful IPO. But, that will hardly compensate them for the risks and likely costs.

Any proposed domestic IPO in China must gain the approval  of China’s CSRC. Even for strong companies, without the legacy of a failed US listing, have a low percentage chance of getting approval. No one knows the exact numbers, but it’s likely last year and this, over 2,000 companies applied for a domestic IPO in China. About 10%-15% of these will succeed. The slightest taint is usually enough to convince the CSRC to reject an application. The taint on these “taken private” Chinese companies will be more than slight. If there’s no certain China IPO, then the whole economic rationale of these “take private” deals is very suspect.  The Chinese company will be then be delisted in the US, and un-listable in China. This will give new meaning to the term “financial purgatory”, privatized Chinese companies without a prayer of ever having tradeable shares again.

Plus, even if they did manage to get CSRC approval, will Chinese retail investors really stampede to buy, at a huge markup, shares of a company that US investors disparaged? I doubt it. How about Hong Kong? It’s not likely their investors will be much more keen on this shopworn US merchandise. Plus, these days, most Chinese company looking for a Hong Kong IPO needs net profits of $50mn and up. These OTCBB and reverse merger victims will rarely, if ever, be that large, even after a few years of spending PE money to expand.

Against all these very real risks, the PE firms can point to what? That valuations are much lower for these OTCBB and reverse merger companies in the US than comparables in China. True. For good reason. The China-quoted comps don’t have bosses foolish or reckless enough to waste a million bucks to do a backdoor listing in the US, and then end up with shares that barely trade, even at a pathetic valuation. Who would you rather trust your money to?

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Shale gas is the most important major new source of energy on the planet, as well as the most important development in the petroleum economy since deep water drilling. Shale gas is reshaping the world’s energy market in a way that even a decade ago seemed unthinkable. This is especially true in the US, where most of the shale gas development is now taking place. Ten years ago, shale gas was just 1% of American natural-gas supplies. Today, it is about 25% and could rise to 50% within two decades. Estimates are that US has more than a 100-year supply of natural gas, thanks to the development of shale gas. Natural gas is used for everything from home heating and cooking to electric generation, industrial processes and petrochemical feedstocks.

Shale gas was first discovered over a century ago. But, it’s only become a commercially-viable source of natural gas with the invention, over the last twenty years, of new drilling technology to break layers of rock and release the gas trapped within. The technology is known as hydraulic fracturing (now widely known as “fracking” or “fracing”). The companies that have played the leading role in developing this technology are mainly all American. They are already making billions of dollars using their techniques to drill deep under the surface across the continental US and harvest the gas trapped there.  The US, which just a few years ago looked to be running out of natural gas, now may someday begin exporting, thanks to its large deposits of shale gas.

The US has long been the world’s largest user and importer of energy. Last year, it was announced that China has overtaken the US in overall energy consumption. Its energy imports are on track to overtake America’s. Although natural gas use is increasing in China, it only comprised 4 percent of the country’s total energy consumption in 2008.

Beneath China’s surface also lies shale gas, most likely quite a lot of it. According to information released by the US Energy Information Administration (EIA) in April, China has 1,275 tcf of technically recoverable shale gas resources, nearly 50% more than the US.  Those estimated recoverable reserves are more than one thousand times the amount of natural gas used in China in 2010.

For China in decades to come, as much as for America, shale gas could be the energy “game-changer”, increasing energy self-reliance and helping to shift the country away from its heavy reliance on coal for electricity generation. Domestic shale gas, if fully exploited, would have enormous impacts not only in China, but worldwide. It could moderate China’s skyrocketing demand for petroleum, one of the primary drivers of higher oil prices. It would mean less coal gets mined and burned, which would have widespread environmental benefits and also ease the strain on the nation’s transportation infrastructure, a large part of which is now devoted to moving coal from where its mined to where its burned for electricity.

China already has more cars and busses running on natural gas than the US. Quite a few cities, including some large ones like Chongqing and Urumqi in Xinjiang, have many of their taxis running on natural gas. There is already a large infrastructure of “natural gas stations” across China. In other words, China stands to benefit, proportionately, even more from the US from a large supply of cheap, domestic natural gas.

The key question is: will China be able to tap its shale gas efficiently? In fact, it may be one of the most important questions in world energy markets over the next five to ten years. The technology is new, complex and almost entirely American. The owners may not be interested to share it with Chinese companies. For one thing, most of the companies with core technology and experience in tapping shale gas are themselves producers, not just suppliers of drilling equipment. Under current rules, they might not find China a very attractive market, especially when the US has so much untapped natural gas, as does neighboring Canada.

China’s leaders clearly understand the importance of shale gas to its economy and the importance of US shale gas technology. China’s goal is to produce 30 billion cubic meters a year from shale, equivalent to almost half the country’s gas consumption in 2008.  In November 2009, US President Barack Obama agreed to share US gas-shale technology with China, and to promote US investment in Chinese shale-gas development.

That sounds more significant than it probably is. President Obama cannot do much to help China, since the US government has little shale gas technology of its own, nor can he provide any real economic incentive for US companies to share technology with China. If there is a good market reason for US companies to drill for shale gas in China, they will surely do it. That is not the case now, as far as I can tell. Energy production and pricing are both heavily controlled by the Chinese government. A US shale gas producer would probably not be able to fully-own a shale gas field in China, nor sell its output at world market prices.  So, my guess is the owners of the best shale gas technology will not likely share it with China.

PetroChina and China National Offshore Oil Corporation (CNOOC) bought stakes in North American shale drillers like Chesapeake Energy and EnCana with the intent of acquiring technology and ramping up production at home. But, it is not certain, to say the least, that this strategy will pay off — becoming a small shareholder is not the same as buying a right to that company’s technology and expertise.

That leaves China with two choices, neither of which is appetizing: first, rely on domestic technology; second, try to obtain US technology by other than legal means. It could take domestic producers a long time to master the technology, and even then, it may not be equal to the best of what the US now has. With the second route, the problem is that it’s not enough just to get hold of drilling equipment. Exploiting shale gas reserves requires a mix of special equipment and know-how, which is far harder to obtain. A lot of the most successful shale gas fields in the US, for example, use horizontal drilling, a method pioneered in US, that allows operators to “ drill down to a certain depth and then to drill at an angle or even sideways. This exposes more of the reservoir, permitting the recovery of a much greater amount of gas,” according to the noted energy researcher Daniel Yergin.

China needs its shale gas, now. It is of vital importance to China, as well as the rest of the developed world. Everyone is hurt if Chinese demand for petroleum continues to push prices higher and higher, especially when there is an attractive alternative, that China shifts more of its energy consumption to natural gas, produced at home.

It’s a troubling sign that China’s Ministry of Land and Resources continues to delay distribution of the country’s first official shale gas blocks. Its first announcements indicated that only Chinese state-owned energy companies could bid on rights to these shale gas deposits.

My preference would be for China’s government to make it as financially rewarding to exploit shale gas there as it is in the US. It can do this with a mix of tax incentives and various rebates available, for example, to US companies that develop shale gas fields in China. The US oil industry doesn’t bother much with politics. They go where there is money to be made.

China will likely spend over $180 billion this year on oil imports, enriching foreigners in places like Iran, Russia and Venezuela. Based on that uncomfortable fact, and that using more natural gas will cut the environmental damage caused by burning so much coal, the rational policy choice is to do about whatever it takes to get US shale gas producers to come to China and start drilling, fraccing and pumping.

My advice: let it be done, and let it be done soon.

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The formula for success in private equity is simple the world over: make lots of money investing other people’s money, keep 20% of the profits and pay little or no taxes on your share of the take. This tax avoidance is perfectly legal. PE firms are usually incorporated as offshore holding companies in tax-free domains like the Cayman Islands.

Depending on their nationality, partners at PE firms may need to pay some tax on the profits distributed to them individually. But, some quick footwork can also keep the taxman at bay. For example, I know PE partners who are Chinese nationals, living in Hong Kong. They plan their lives to be sure not to be in either Hong Kong or China for more than 182 days a year, and so escape most individual taxes as well. Even when they pay, it’s usually at the capital gains rate, which is generally far lower than income tax.

The tax efficiency is fundamental to private equity, and most other forms of fiduciary investing. If the PE firm’s profits were assessed with income tax ahead of distributions to Limited Partners (“LPs”), it would significantly reduce the overall rate of return, to say nothing about potentially incurring double taxation when those LPs share of profits got dinged again by the tax man.

China, as everyone in the PE world knows, is very keen to foster growth of its own homegrown private equity firms. It has introduced a raft of new rules to allow PE firms to incorporate, invest Renminbi and exit via IPO in China. So far so good. The Chinese government is also pouring huge sums of its own cash into private equity, either directly through state-owned companies and agencies, or indirectly through the country’s pay-as-you-go social security fund. (See my recent blog post here.)

Exact figures are hard to come by. But, it’s a safe bet that at least Rmb100 billion (USD$15 billion) in capital was committed to domestic private equity firms last year. This year should see even larger number of new domestic PE firms established, and even larger quadrants of capital poured in.

It’s going to be a few years yet before the successful Chinese domestic PE firms start returning significant investment profits to their investors. When they do, their investors will likely be in for something of an unpleasant surprise: the PE firms’ profits, almost certainly, will be reduced by as much as 25% because of income tax.

In other words, along with building a large homegrown PE industry that can rival those of the US and Europe, China is also determined to assess those domestic PE firms with sizable income taxes. These two policy priorities may turn out to be wholly incompatible. PE firms, more than most, have a deep, structural aversion to paying income tax on their profits. For one thing, doing so will cut dramatically into the personal profits earned by PE partners, lowering significantly the after-tax returns for these professionals. If so, the good ones will be tempted to move to Hong Kong to keep more of their share of the profits they earn investing others’ money. If so, then China could get deprived of some experienced and talented PE partners its young industry can ill afford to lose.

It’s still early days for the PE industry in China. Renminbi PE firms really only got started two years ago. I’ve yet to hear any partners of domestic PE firms complain. But, my guess is that the complaining will begin just as soon as these PE firms begin to have successful exits and begin to write very large checks to the Chinese tax bureau. What then?

China’s tax code is nothing if not fluid. New tax rules are announced and implemented on a weekly basis. Sometimes taxes go down. Most often lately, they go up.  Compared to developed countries, changing the tax code in China is simpler, speedier. So, if the Chinese government discovers that taxing PE firms is causing problems, it can reverse the policy rather quickly.

The PE firms will likely argue that taxing their profits will end up hurting hundreds of millions of ordinary Chinese whose pensions will be smaller because the PE firms’ gains are subject to tax. In industry, this is known as the “widows and orphans defense”. Chinese contribute a share of their paycheck to the state pension system, which then invests this amount on their behalf, including about 10% going to PE investment.

PE firms outside China are structured as offshore companies, with offices in places like London, New York and Hong Kong, but a tax presence in low- and no-tax domains. But, there’s currently no real way to do this in China, to raise, invest and earn Renminbi in an offshore entity. Changing that opens up an even larger can of worms, the current restrictions preventing most companies or individuals outside China from holding or investing Renminbi. This restriction plays a key part in China’s all-important Renminbi exchange rate policy, and management of the country’s nearly $2.8 trillion of foreign reserves.

The world’s major PE firms are excitedly now raising Renminbi funds. Several have already succeeded, including Carlyle and TPG. They want access to domestic investment opportunities as well as the high exit multiples on China’s stock market. When and if the income tax rules start to bite and the firm’s partners get a look at their diminished take, they may find the appeal of working and investing in China far less alluring.

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