Around the time of Confucius 2,500 years ago, the Greek philosopher Heraclitus wrote, “Nothing is permanent except change.” It’s a perfect quick summary of the private equity industry in China. In its short 20 year history, PE in China has undergone continuous transformation: from dollars to Renminbi; from a focus on technology companies to a preference for traditional industries; from overseas IPO exits to domestic listings;  from a minor financing channel to a main artery of capital to profitable private companies competing in the most dynamic and fast-growing major market in the world.

Where is private equity in China headed? Can future performance match the phenomenal returns of recent years? Where in China are great entrepreneurial opportunities and companies emerging? These are some of the questions we’ve sought to answer in China First Capital’s latest English-language research report, titled “Private Equity in China, Positive Trends and Growing Challenges”.

You can download a copy by clicking:  Download “Private Equity in China, 2012 – 2013“.

Our view is that 2012 will be a year of increasingly fast realignment in the PE industry. With the US capital markets effectively closed to most Chinese companies, and Hong Kong Stock Exchange ever less welcoming and attractive, the primary exit paths for China PE deals are domestic IPO and M&A. Both routes are challenging. At the same time, there are too many dollar-based investors chasing too few quality larger deals in China.

“Adapt or die” describes both the Darwinian process of natural selection as well as the most effective business strategy for PE investing in China.

I’ve been working with entrepreneurs for most of my 30 year business career. It’s the joy and purpose of my life. Good entrepreneurs profit from change and uncertainty. Investors less so, if at all. This may be the biggest misalignment of all in Chinese PE. The entrepreneurial mindset is comfortable with constant change, with the destruction and opportunity created by market innovation. In my view, the PE firms most likely to succeed in China are those led by professionals with this same entrepreneurial mindset.

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Most investors, including me,  would be delighted to make 15% to 20% per year, year after year. But, for many private equity firms active in China, that kind of return would be cause for shame. The reason is that recent past returns from Chinese PE , and so the expectations of LPs, is much higher, often overall annual increases of 40%-60% a year, with successful individual deals increasing by 100% a year in value during a typical three to five year holding period.

But, it is quickly becoming much more challenging to earn those +40% annual rates of return. My prediction is that profits from PE investing in China will soon begin a rather steep downward slide. This isn’t because there are fewer good Chinese companies to invest, or that valuations are rising sharply. Neither is true. It’s simply that a declining percentage of PE deals done in China will achieve those exceptionally high profits of 500%-800% or more over the life of an investment.

The reason is that fewer and fewer PE deals in China will achieve exit through IPO. Those are the deals where the big money is made. There are no precise numbers. But, my estimate would be that in recent years, one in four PE investments made by the top 50 firms active in China managed to have an IPO. Those are the deals with the outsized rates of return that do so much to lift a PE firm’s overall IRR.

In the future, the rate of successful IPO exit may fall by 30% or more for the good firms. For lesser PE firms, including many of the hundreds of Renminbi firms set up over the last three years, the percentage of deals achieving a domestic IPO in China may not reach 10%. If so, overall returns for each PE firm, as well as the industry as a whole, will fall rather dramatically from the high levels of recent years.

The returns for most PE and VC firms across the world tend toward bell curve distribution, with a small number of highly successful deals more than covering losses at the deals gone sour, and the majority of deals achieving modest increases or declines. In China, however, the successful deals have tended to be both more numerous and more profitable.  This has provided most of the propulsive thrust for the high rates of return.

The higher the rate of return, the easier it is to raise new money. PE firms each year keep 1% to 2% of the money they raise every year as a management fee. It’s a kind of tithe paid by LPs. PE firms also usually keep 20% of the net investment profits. But, this management fee is risk-free, and usually is enough to fully pay for the PE and VC firms salaries, offices, travel and other operating expenses, with anything left over split among the partners.

So, high rates of investment return in the past ends up translating into lots of new money unlinked to actual investment performance in the future. It’s a neat trick, and explains why the PE partners currently most actively out raising capital are mainly those investing in China. The more you raise now, the longer your guaranteed years of the good life. In other words, even if overall investment results deteriorate in coming years, the guaranteed income of PE firms will remain strong. Most funds have a planned lifespan of seven to ten years. So, if you raise $1 billion in 2012, you will have perhaps $20mn a year in guaranteed management fee income all the way through 2022.

The more new capital that’s raised for PE deals in China, the more investment deals can get done. The problem is, IPOs in China are basically a fixed commodity, with about 250 private companies going public a year. These domestic Chinese IPOs are the common thread linking most of the highest return PE deals. The Chinese IPOs will continue, and most likely continue to provide some of the highest profits available to PE firms anywhere. But, with the number of IPOs static and overall PE investment surging, the odds of a PE-backed company in China getting the green light for IPO will drop — rather precipitously if the current gusher of new money for PE deals in China persists.

Meantime, the number of Chinese companies going public outside China is dropping and will likely continue to. The US has all but barred the door to Chinese companies, following a spate of stories in 2011 about fraudulent accounting and false disclosure by Chinese companies quoted there. In Hong Kong, the only Chinese companies generating investor enthusiasm at IPO are ones with both significant size (profits of at least USD$25mn) and an offshore legal corporate structure. It used to be both simple and common for Chinese companies to set up holding companies outside China. The Chinese government has moved aggressively to shut down that practice, beginning in 2006. So, the number of private Chinese companies with the legal structure permitting a Hong Kong (or US, Singapore, Korean, Australian) IPO will continue to shrink.

Add it up and the return numbers for PE firms active in China begin to look much less rosy going forward than they have in the past. More deals will end in mandatory buybacks, rather than IPOs. This is the escape mechanism written into just about every PE investment contract. It allows the PE firm to sell their shares back to the company if an IPO doesn’t take place within a specified period of time, typically three to five years. The PE gets its original investment back, plus an annual rate of return (“IRR”), usually 10% to 20%.

This way PE firms can’t get stuck in an illiquid investment. The buybacks should become an increasingly common exit route for PE deals in China. But, they only work when the company can come up with the cash to buy the PE shares back. That will not always be certain, since pooling large sums of money to pay off an old investor is hardly the best use of corporate capital. Fighting it out in court will likely be a fraught process for both sides.

The direction of Chinese PE is moving from IPO to IRR.  As this process unfolds, and PE returns in China begin to trend downward, the PE investment process and valuations are likely to change, most likely for the worse. IRR deals seldom make anyone happy—not the PE firms, their LPs or the entrepreneur.

Chinese PE still offers some of the best risk-adjusted returns of any investment class. But, as often happens, the outsized returns of recent years attracts a glut of new money, leading to an eventual decline in overall profits. In investing, big success today often breeds mediocrity tomorrow.

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From the world’s leading IPO stock market to a grubby financial backwater with the sordid practices of America’s notorious OTCBB. Is this what’s to become of the Hong Kong Stock Exchange ?

I see some rather disturbing signs of this happening. Underwriters, with the pipeline of viable IPO deals drying up, are fanning out across China searching for mandates and making promises every bit as mendacious and self-serving as the rogues who steered so many Chinese companies to their doom on the US OTCBB.

The Hong Kong Stock Exchange (“HKSE”) may be going wrong because so much, until recently, was going right.  Thanks largely to a flood of IPO offerings by large Chinese companies, the HKSE overtook New York in 2009 to become the top capital market for new flotations. While the IPO markets turned sharply downward last year, and the amount of IPO capital raised in Hong Kong fell by half, the HKSE held onto the top spot in 2011. US IPO activity remains subdued, in part due to regulatory burdens and compliance costs heaped onto the IPO process in the US over the last decade.

During the boom years beginning around 2007, all underwriting firms bulked up by adding expensive staff in expensive Hong Kong. This includes global giants like Goldman Sachs, Citibank and Morgan Stanley, smaller Asian and European firms like DBS, Nomura, BNP Paribas and Deutsche Bank and the broking arms of giant Chinese financial firms CITIC, ICBC, CIIC, and Bank of China. The assumption among many market players was that the HKSE’s growth would continue to surge, thanks largely to Chinese listings, for years to come. With the US, Europe and Japan all in the economic and capital market doldrums, the investment banking flotilla came sailing into Hong Kong. Champagne corks popped. High-end Hong Kong property prices, already crazily out of synch with local buying power,  climbed still higher.

The underwriting business relies rather heavily on hype and boundless optimism to sell new securities. It’s little surprise, then, that IPO investment bankers should be prone to some irrational exuberance when it comes to evaluating their own career prospects. The grimmer reality was always starkly clear. For fundamental reasons visible to all but ignored by many, the flood of quality Chinese IPOs in Hong Kong was always certain to dry up. It has already begun to do so.

In 2006, the Chinese government closed the legal loophole that allowed many PRC companies to redomicile in Hong Kong, BVI or Cayman Islands. This, in turn, let them pursue IPOs outside China, principally in the US and Hong Kong. Every year, the number of PRC companies with this “offshore structure” and the scale and growth to qualify for an IPO in Hong Kong continues to decline. A domestic Chinese company cannot, in broad terms, have an IPO outside China.

Some clever lawyers came up with some legal fixes, including a legally-dubious structure called “Variable Interest Entity”, or VIE, to allow domestic Chinese companies to list abroad. But, last year, the Chinese Ministry of Commerce began moving to shut these down. The efficient, high-priced IPO machine for listing Chinese companies in Hong Kong is slowly, but surely, being starved of its fuel: good Chinese private companies, attractive to investors.

Yes, there still are non-Chinese companies like Italy’s Prada, Russia’s Rusal or Mongolia’s Erdenes Tavan Tolgoi still eager to list in Hong Kong. There is still a lot of capital, while listing and compliance costs are well below those in the US. But, the Hong Kong underwriting industry is staffed-up mainly to do Chinese IPOs. These guys don’t speak Russian or Mongolian.

So, the sorry situation today is that Hong Kong underwriters are overstuffed with overhead for a “coming boom” of Chinese IPOs that will almost certainly never arrive. China-focused Hong Kong investment bankers are beginning to show signs of growing desperation. Their jobs depend on winning mandates, as well as closing IPOs. To get business, the underwriters are resorting, at least in some cases, to behaviors that seem not that different from the corrupt world of OTCBB listing. This means making some patently false promises to Chinese companies about valuation levels they could achieve in an Hong Kong IPO.

The reality now is that valuation levels for most of the Chinese companies legally structured for IPO in Hong Kong are pathetically low. Valuations keep getting slashed to attract investors who still aren’t showing much interest. Underwriters are finding it hard to solicit buy offers for good Chinese companies at prices of six to eight times this year’s earnings. Some other deals now in the market and nowhere near close are being priced below four times this year’s net income. At those kind of prices, a HK IPO becomes some of the most expensive equity capital around.

In their pursuit of new mandates, however, these Hong Kong underwriters will rarely share this information with Chinese bosses. Instead, they bring with them handsomely-bound bilingual IPO prospectuses for past deals and suggest that valuation levels will go back into double digits in the second half of this year. In other words, the pitch is, “don’t look at today’s reality, focus instead at yesterday’s outcomes and my rosy forecast about tomorrow’s”.

This is the same script used by the advisors who peddled the OTCBB listings that damaged or destroyed so many Chinese companies over the last five years. Another similar tactic used both by OTCBB rogues and HK underwriters is to pray on fear. They suggest to Chinese bosses that they should protect their fortune by listing their company offshore, at whatever price possible and using whatever legally dubious method is available. They also play up the fact a Chinese company theoretically can go public in Hong Kong whenever it likes, rather than wait in an IPO queue of uncertain length and duration, as is true in China.

In other words, the discussion concerns just about everything of importance except the fact that valuation levels in Hong Kong are awful, and there is a decent probability a Chinese company’s HK IPO will fail. This is particularly the case for Chinese companies with less than USD$25 million in net income. The cost to a Chinese company of a failed IPO is a lot of wasted time, at least a million dollars in legal and accounting bills as well as a stained reputation.

There is, increasingly, a negative selection bias. Investors rightly wonder about the quality of Chinese companies, particularly smaller ones, being brought to market by underwriters in Hong Kong.

“No one has a crystal ball”, is how one Hong Kong underwriter, a managing director who spends most of his time in China scouring for mandates, explains the big gap between promises made to Chinese bosses, and the sad reality that many then encounter. In a real sense, this is on par with him saying “I’ve got to do whatever I’ve got to do to earn a living”. He can hold onto his job for now by bringing in new mandates, then hope markets will turn around at some point, the valuation tide will rise, and these boats will lift. This too is a business strategy used for many years by the OTCBB advisor crowd.

The OTCBB racket is now basically shut down. Those who profited from it are now looking for work or looking elsewhere for victims, er mandates. Tiny cleantech deals are apparently now hot.

My prediction is a similar retrenchment is on the way in Hong Kong, only this time those being retrenched won’t be fast-buck types from law firms and tiny OTCBB investment banks no one has heard of. Instead, it’ll be bankers with big salaries working at well-known brokerage companies. The pool of IPO fees isn’t big enough to feed them all now. And, that pool is likely going to evaporate further, as fewer Chinese companies sign on for Hong Kong listings and successfully close deals.

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Capital allocation, not the amount of capital,  is the largest financial challenge confronting the private equity industry in China. Capital continues to flood into the PE sector in China. 2011 was a record year, with over $30billion in new capital raised by PE firms, including both funds investing in dollars and those investing in Renminbi. China’s private equity industry seems destined now to outstrip in size that of every other country, with exception of the US. Ten years ago, the industry hardly existed in China.

Yes, it is a time of plenty. Yet, plenty of problems remain. Many of the best private companies remain starved of capital, as China’s domestic banks continue to choke back on their lending. As a result, PE firms will play an increasingly vital role in providing growth capital to these companies. 

These are some of the key themes addressed in CFC’s latest research report, titled “2012-2013: 中国私募股权融资与市场趋势”. It can be downloaded from the CFC website or by clicking here.

The report is available in Chinese only.

Like many of CFC’s research reports, this latest one is intended primarily for reference by China’s entrepreneurs and company bosses. Private equity, particularly funds able to invest Renminbi into domestic companies,  is still a comparatively new phenomenon in China. Entrepreneurs remain, for the most part, unfamiliar with all but the basics of growth capital investment. The report assesses both costs and benefits of raising PE.

This calculus has some unique components in China. Private equity is often not just the only source for growth capital, it is also, in many cases, a pre-condition to gaining approval from the CSRC for a domestic IPO. It’s a somewhat odd concept for someone with a background only in US or European private equity. But, from an entrepreneur’s perspective, raising private equity in China is a kind of toll booth on the road to IPO. The entrepreneurs sells the PE firm a chunk of his company (usually 15%-20%) for a price significantly below comparable quoted companies’ valuation. The PE firm then manages the IPO approval process.

Most Chinese companies that apply for domestic IPO are turned down by the CSRC. Bringing in a PE firm can often greatly improve the odds of success. If a company is approved for domestic IPO, its valuation will likely be at least three to four times higher (on price/earnings basis) than the level at which the PE firm invested. Thus, both PE firm and entrepreneur stand to benefit.

The CSRC relies on PE firms’ pre-investment due diligence when assessing the quality and reliability of a company’s accounting and growth strategy. If a PE firm (particularly one of the leading firms, with significant experience and successful IPO exits in China) is willing to commit its own money, it provides that extra level of confidence the CSRC is looking for before it allows a Chinese company to take money from Chinese retail investors.

From a Chinese entrepreneur’s perspective, the stark reality is “No PE, No IPO”.

CFC’s Jessie Wu did most of the heavy lifting in preparing this latest report, which also digests some material previously published in columns I write for “21 Century Business Herald” (“21世纪经济报道) and “Forbes China”  (“福布斯中文”). The cover photo is a Ming Dynasty Xuande vase.

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The amount of capital going into private equity in China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors,  remains puny in China. 

This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. No one has yet focused on this issue. But, it is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China. 

Here’s a way to understand the problem: there is probably now over $50 billion in capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. 

At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Thousands of companies are waiting for approval, and thousands more will likely join the queue each year by submitting IPO applications to the CSRC.

Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRC’s primary role is to assure the stability of China’s capital markets, not to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. 

Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, it’s generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$20 million, that are most welcome.

In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, “Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread.”

Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias.  Bad Chinese companies go where good companies dare not tread. 

For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. That’s fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms’ overall investment performance.

Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove impossible for these firms to do as well with new money as they did with the old. 

These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newly-established Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. 

When I discuss this with PE partners, the usual answer is they expect exits through M&A to increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. I do agree that the percentage of Chinese PE deals achieving exit through M&A will increase from the current level. It could barely be any lower than it is now.

But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal,  the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. 

Measured by new capital raised and investment results achieved, China’s private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year,  the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will be a little less comfortable if, as seems likely,  a diminishing number of the investments made in Chinese companies have a big IPO payday.

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.  

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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Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.

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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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Back-to-back articles over the last several days in two Chinese dailies, Shenzhen Economic Daily (深圳商报)and Tianjin Ribao (天津日报). In both, I’m rather extensively quoted. You can read them here:

Shenzhen Economic Daily

Tianjin Ribao

For those whose Chinese is wanting (as is mine, some of the time), the Shenzhen Economic Daily article discusses the difficulties Chinese companies have run into after getting listed in the US stock market. One possible solution is to “de-list” these companies, by buying out all public shareholders, then applying for an IPO in China. Could it work? Perhaps, but my guess is that a Chinese company trying the Prodigal Son technique will likely meet with much skepticism from Chinese retail investors.

The article in the Tianjin Ribao is a general survey of developments in private equity in China. It discusses the shifting locus of PE investment towards inland China. This is a development I embrace. The vast majority of China’s vast population lives in places that have no outside equity capital, and no private companies on the stock market.

Over the last six months, I put in the time to prospect in regions that have thus far received little, to no, private equity. I’ve visited companies in Guizhou, Yunnan, Guangxi, Hunan, Sichuan, Qinghai, Henan, Liaoning, Xinjiang, Hebei, Shandong. We’ve taken on clients in quite a number of these. I hope to add more. The one constant in all these prospecting trips: there are outstanding entrepreneurs running outstanding businesses in every corner of this country.

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2010 is the year China’s private equity industry hit the big time. The amount of new capital raised by PE firms reached an all-time high, exceeding Rmb150 billion (USD $23 billion). In particular, Renminbi PE funds witnessed explosive growth in 2010, both in number of new funds and amount of new capital. China’s National Social Security Fund accelerated the process of investing part of the country’s retirement savings in PE. At the same time, the country’s largest insurance companies received approval to begin investing directly in PE, which could add hundreds of billions of Renminbi in new capital to the pool available for pre-IPO investing in China’s private companies.

China First Capital has just published its third annual report on private equity in China. It is available in Chinese only by clicking here:  CFC 2011 Report. Or, you can download directly from the Research Reports section of the CFC website.

The report is illustrated with examples of Shang Dynasty bronze ware. I returned recently from Anyang, in Henan. Anyone with even a passing interest in these early Chinese bronze wares should visit the city’s splendid Yinxu Museum.

This strong acceleration of the PE industry in China contrasts with situation in the rest of the world. In the US and Europe, both PE and VC investments remained at levels significantly lower than in 2007. IPO activity in these areas remains subdued, while the number of Chinese companies going public, and the amount of capital raised, both reached new records in 2010. There is every sign 2011 will surpass 2010 and so widen even farther the gap separating IPO activity for Chinese companies and those elsewhere.

The new CFC report argues that China’s PE industry has three important and sustainable advantages compared to other parts of the world. They are:

1. High economic growth – at least five times higher in 2010 than the rate of gdp growth in the US and Europe
2. Active IPO market domestically, with high p/e multiples and strong investor demand for shares in newly-listed companies
3. A large reservoir of strong private companies that are looking to raise equity capital before an IPO

CFC expects these three trends to continue during 2011 and beyond. Also important is the fact that the geographic scope of PE investment in China is now extending outside Eastern China into new areas, including Western China, Shandong,  Sichuan. Previously, most of China’s PE investment was concentrated in just four provinces (Guangdong, Fujian, Zhejiang, Jiangsu) and its two major cities, Beijing and Shanghai. These areas of China now generally have lower rates of economic growth, higher labor costs and more mature local markets than in regions once thought to be backwaters.

PE investment is a bet on the future, a prediction on what customers will be buying in three to five years. That is the usual time horizon from investment to exit. China’s domestic market is highly dynamic and fast-changing. A company can go from founding to market leadership in that same 3-5 year period.  At the same time, today’s market leaders can easily fall behind, fail to anticipate either competition or changing consumer tastes.

This Schumpetrian process of “creative destruction” is particularly prevalent in China. Markets in China are growing so quickly, alongside increases in consumer spending, that companies offering new products and services can grow extraordinary quickly.  At its core, PE investment seeks to identify these “creative destroyers”, then provide them with additional capital to grow more quickly and outmaneuver incumbents. When PE firms are successful doing this, they can earn enormous returns.

One excellent example: a $5 million investment made by Goldman Sachs PE in Shenzhen pharmaceutical company Hepalink in 2007.  When Hepalink had its IPO in 2010, Goldman Sachs’ investment had appreciated by over 220 times, to a market value of over $1 billion.

Risk and return are calibrated. Technology investments have higher rates of return (as in example of Goldman Sachs’s investment in Hepalink)  as well as higher rates of failure. China’s PE industry is now shifting away from investing in companies with interesting new technologies but no revenue to PE investment in traditional industries like retail, consumer products, resource extraction.  For PE firms, this lowers the risk of an investment becoming a complete loss. Rates of return in traditional industries are often still quite attractive by international standards.

For example: A client of CFC in the traditional copper wire industry got PE investment in 2008. This company expects to have its IPO in Hong Kong later this year. When it does, the PE firm’s investment will have risen by over 10-fold.  Our client went from being one of numerous smaller-scale producers to being among China’s largest and most profitable in the industry. In capital intensive industries, private companies’ access to capital is still limited. Those firms that can raise PE money and put it to work expanding output can quickly lower costs and seize large amounts of market share.

Our view: the risk-adjusted returns in Chinese private equity will continue to outpace most other classes of investing anywhere in the world. China will remain in the vanguard of the world’s alternative investment industry for many long years to come.

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

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

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

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

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

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

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

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

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

What’s Behind China’s Reverse IPOs?

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

By JOSEPH STERNBERG

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

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

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

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

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

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

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

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

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

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

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