China Private Equity

My congratulations, both personal and professional, to Carlyle Group, which announced last week the launch of its first RMB fund, in partnership with China’s Fosun Group. I happen to know some of the people working at Carlyle in China, and I’m excited about the news, and how it will positively impact their careers. 

Carlyle is the first among the private equity industry’s global elite to take this giant public step forward in raising renminbi in partnership with leading Chinese private company. It marks an important milestone in the short but impressive history of private equity in China, and points the way forward for many of the private equity firms already established in China. 

The initial size of the new renminbi fund is $100mn. By Carlyle’s standards, this seems almost like a rounding error – representing a little more than 0.1% of Carlyle’s total assets of $90 billion.  But, don’t let the size fool you. For Carlyle, the new renminbi fund just might play an important role in the firm’s future, as well as China’s. 

The reason: Carlyle will now be able to use renminbi to invest more easily in domestic companies in China, then help take them public in China, on the Shanghai or Shenzhen stock markets. Up to now, Carlyle’s investments in China, like those of its global competitors, have been mainly in dollars, into companies that were structured for a public listing outside China. Carlyle has a lot to gain, since IPO valuations are at least twice as high in China as they are in Hong Kong or USA. 

That means an renminbi investment leading to a Chinese IPO can earn Carlyle a much higher return, likely over 300% higher, than deals they are now doing.  By the way, the deals they are now doing in China are anything but shabby, often earning upwards of five times return in under two years. Access to renminbi potentially will make returns of 10X more routine.  Carlyle has ambitious plans to keep raising renminbi, and push the total well above the current level of $100mn. 

As rosy as things look for Carlyle, the biggest beneficiary may well turn out to be the Chinese companies that land some of this Carlyle money. PE capital is not in short supply in China, including an increasing amount of renminbi. But, smart capital is always at a premium. Capital doesn’t get much smarter – or PE investing more disciplined — than Carlyle. They have the scale, people, track record and value-added approach to make a significant positive impact on the Chinese companies they invest in. 

This is the key point: the best opportunities in private equity are migrating towards those firms that have both renminbi and a highly professional approach to investing. That’s why the leading global PE firms will likely join Carlyle in raising renminbi funds. Blackstone is already hard at work on this, and rumors are that TPG and KKR are also in the hunt. 

Carlyle now joins a very select group of world-class PE firms with access to renminbi. The others are SAIF, CDH, Hony Capital, Legend Capital and New Horizon Fund. These firms are all focused primarily (in the case of SAIF) or exclusively on China. While they lack Carlyle’s scale or global reach, they more than make up for it by commanding the best deal flow in China. SAIF, CDH, Hony, Legend and New Horizon have all been around awhile, starting first as dollar-based investors, and then gradually building up pool of renminbi, including most recently funds from China’s national state pension system. 

Like Carlyle, they also have outstanding people, and very high standards. They are all great firms, and are a cut above the rest. Up to now, they have done more deals in China than Carlyle, and know best how to do renminbi deals. Carlyle and other big global PE firms will learn quickly.  As they raise renminbi, they will elevate the overall level of the PE industry in China, as well as increase the capital available for investment. 

The certain outcome: more of China’s strong private SMEs will get pre-IPO growth capital from firms with the know-how and capital to build great public companies.

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.

The current issue of “Corporate Finance Magazine” has a Chinese-language research report written by the China First Capital management team. It’s the cover story. The title of the report is: “如何选择上市的时机和地点”. It examines some of the right  and wrong ways for a Chinese SME to IPO. 

The article begins on page 10. Download report here

We are very happy about the planned opening of trading later this month on the new Growth Enterprise Market (创业板 ) here in Shenzhen. We hope it will give many successful SME new opportunities to go public properly and efficiently.

Our goal is that the report in Corporate Finance will contribute towards a successful future for the Growth Enterprise Market and for all of China’s best-performing SME. 

“Manage people’s expectations. Then, exceed them.” That’s not a bad rule to live by, or management principle to apply in regulating China’s fast-moving capital markets. This past week, China Regulatory Securities Commission, the nation’s stock market regulator, moved one step closer to opening trading in the new, Shenzhen-based, Growth Enterprise Market. It’s been ten years in the planning. The names were finally announced of the first companies that will list on the new market when trading begins later in October. All are private SME, and several had pre-IPO private equity funding.

The total amount of capital this first crop of IPOs will raise is well above most earlier estimates. The original stated plan was for smaller companies to list on the GEM, which, in turn, suggested the GEM market would be only a marginal contributor of growth capital for private SME. The minimum requirement was set at just $1.5mn in aggregate profits over the last two years. Even at high Chinese multiples, firms of that size would struggle to raise more than $10mn in an IPO.

But, in something of a surprise, CSRC chose larger companies to be in the first group to list. It now looks like that the ten companies will raise a total of over $400mn when their IPOs close, or an average of $40mn each. This, in turn, points to a cumulative market capitalization for this first group of around $2 billion. That bodes well for the market’s long-term future. A larger market capitalization means more liquidity and so less volatility in the share price. This will help attract more capital to the new Shenzhen market, and to subsequent future IPOs there.

Bravo, I say! The CSRC may well get the formula right, and so prove that these smaller-capitalization “growth stock markets” can work, both for companies and investors.

Elsewhere, these growth stock markets have mainly failed in their stated purpose to create an efficient platform for smaller companies to attract investors and raise capital. Germany’s Neuer Markt shut down soon after it was created. The small-cap markets in Singapore and Hong Kong have been disappointments. Small-cap companies stayed small-cap companies, which is entirely contrary to the purpose of a “growth board” like this. The granddaddy of them all, America’s OTC Bulletin Board, has become an all-purpose dumping ground for shady American firms, stock manipulators, and, sadly, several hundred once-strong Chinese SME who listed there after taking very bad advice from self-interested advisors and brokers looking to make a quick buck.

It’s anybody’s guess how many companies will list on Shenzhen’s GEM this year, or next. There is a backlog of at least 100 that have applied, and been provisionally accepted by CSRC. One thing we know: each IPO in China will get its final approval as part of an orderly process that takes into account the performance of companies already listed on GEM, and stock prices trends overall.

The Shenzhen GEM shows every sign of beginning to fill a very large, very important funding gap in China. Assuming, as I hope, that CSRC continues its preference for companies able to raise at least $30mn-$40mn in a public listing, these IPOs will channel capital to companies who would otherwise find it very hard to come by. Most of the private equity and venture firms that we work with don’t write checks that large. They generally invest around $10mn-$25mn in pre-IPO equity capital to own 20%-30% of a private Chinese SME. These investments are done at valuations of around eight times last year’s profits. So, a GEM listing could become the best source of growth capital for an SME that already has achieved some success, has profits of over $10mn-$20mn a year, but is still too small for a main board listing, in China or outside.

The public markets have two big advantages over private equity financing: they offer much higher price-earnings valuations, and give shareholders a liquid market to trade their shares. On the other hand, for Chinese SME, staging an IPO in China always has a level of deep unpredictability. The CSRC makes all the decisions about which companies can IPO and when. So, SME can wait two years or more to apply, get approval, and then put the IPO proceeds in the bank. If that SME is now growing quickly, has outsized opportunities near-to-hand with a high rate of return, but can’t finance its growth internally or with bank debt, a round of private equity will almost certainly be the best route to follow.

Done right (see my earlier blog post, on Foshan Saturday ’s IPO) a company’s market capitalization, when it eventually completes its IPO, can be at least three times larger than it is at present. That means the laoban gets richer (nothing wrong with that), and investors are happier, too, because of the increased liquidity and stability from the higher market cap at IPO.

I’m extremely positive about the role the GEM will play in helping to build even stronger private Chinese SME. The CSRC and Chinese government have taken over ten years to plan this new stock market, and learn from the mistakes of others. All signs now are that they have done so, and the GEM will gradually create a group of publicly-traded private companies that will go on to achieve far more impressive results in the future.

Though not in a ringside seat, I nonetheless had a privileged, up-close view of last week’s IPO for Foshan Saturday Shoes. That’s thanks to my friendship with Cao Yuhui, a partner at King & Wood law firm, and Foshan Saturday’s main corporate lawyer for the last several years.  It was a successful IPO by a very successful, well-run company. Foshan Saturday, a maker of high-end women’s shoes, raised over Rmb900mn in the IPO, selling about 20% of its equity. The share price closed up almost 20% on the first day of trading. The market cap is now closing in on Rmb5 billion. 

For Yuhui, it’s a great personal success. He first started advising the company when they were well along in their planning for what would have been a very ill-advised IPO in Singapore in 2006. Instead, Yuhui worked with the company to close a round of PE finance in 2007. Legend Capital, the venture capital arm of China’s largest computer manufacturer, invested Rmb 40 million in 2007. Over the following two years, sales and profits at Foshan Saturday more than doubled. It’s now the fourth-largest women’s shoe company in China, with a widely-known brand, and sales this year of over Rmb 1 billion. 

Legend is expected to liquidate its ownership in Foshan Saturday, and should earn a return of five times on its original investment – which is another way of saying that Foshan Saturday’s enterprise value increased five-fold during the time Legend was involved. So, while the VC firm did well, Foshan Saturday’s owner did even better. He is now sitting on a personal stake in the company worth over $350 million. He started the company just seven years ago. 

Foshan is a relatively small city by Chinese standards, with a population of about 5.5 million. It’s about two hours drive up the Guangdong coast from Shenzhen. It’s residents are known both for business acumen and personal modesty. 

Foshan Saturday is a textbook case of everything going right for a Chinese SME. The company was among the first to see the great potential for developing native Chinese fashion brands. They never bothered with OEM export manufacturing, but focused from the start on building a brand for young, Chinese urban females.

Even more crucial to its success, the company backed away from plans for that early IPO in 2006. The company then was a third of its current size. Many Chinese companies who chose to list in Singapore have since lived to regret it. The market has had few stellar performers among the Chinese SME listed there. Most have stumbled along with low earnings multiples, and as a result, quite a few have tried to delist in Singapore and try to float their shares on China’s domestic market. 

Foshan Saturday took the far better course of raising pre-IPO capital, from one of the better firms active in China. They raised only Rmb 40 million, but put it to use efficiently enough to accelerate growth by over 200%. In other words, as in all good investment opportunities among China’s SME, there was a very good place to put a reasonably small amount of capital to work, and earn significant returns. 

A lot of that growth came from an efficient strategy of opening retail counters inside shopping malls, where in lieu of rent, Foshan Saturday pays a share of revenue to the landlord. This limits the amount of capital needed to open new outlets. Foshan Saturday now has 1,200. About half the money raised in the IPO will go to opening still more retail outlets. 

A recent blog post by the Forbes bureau chief in China took a little swipe at me, saying Fuhrman “claims it is not too hard to pick winners that will quadruple your money in just a few years.” The Forbes writer (who I’ve never met) seems to think I’m daft. Yet, as the example of Foshan Saturday shows, it’s not all that hard to that well, or better.

From what I could gather, Legend Capital didn’t play a highly active role in the company. They knew a solid strategy when they saw one. So, they let the Foshan Saturday team execute, and then sat back and let the money start to roll in.  Result: profit to the VC firm of about $30 million on an investment of under $6 million. 

My friend Yuhui threw a big party at one of Shenzhen’s swankiest nightclubs to celebrate the IPO’s success. I wasn’t able to go, since I was traveling in Zhejiang. He told me later that there were about 60 guests, mainly mid and senior management from Foshan Saturday. They ran up a bar tab of around $1,500. 

I’m not big on drinking, but would have been happy to celebrate with them. Not just Foshan Saturday and Cao Yuhui did well from the IPO. It’s going to make it easier for other strong Chinese SME to achieve a similar success in years to come.

The roadmap is clear. It’s a three-step path to success for a successful IPO by a Chinese SME : (1) resist the lure of an early IPO; (2) bring in a good PE or VC investor to put more capital to work in ways that will earn a high return; and (3) stage an IPO several years later when the business has at least doubled its size. 

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

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

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

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

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

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

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

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

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

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

. 

One of the main themes of the PE conference I attended last week in Shanghai was the launch of the Shenzhen Stock Exchange’s new Growth Enterprise Market “GEM”, for smaller-cap, mainly high-tech companies.

It’s been a long time in the planning – since at least 1999. In March 2008, China’s Prime Minister, Wen Jiabao, tried to kickstart the process and announced plans to open soon this second market in Shenzhen. Events then intruded – the credit crisis struck, financial markets tanked, and so plans for China’s GEM went into limbo.

Things are now back on track. Trading is likely to begin in October. At the conference, most of the speakers focused on hows and whys the GEM would open new opportunities for smaller companies to raise money from China’s capital market.

Overall, it’s a development I applaud. Private companies in China are often starved of growth capital, and the GEM will mean more of the country’s capital gets allocated to these businesses.

There is one aspect, however, of the GEM that I personally find a little less positive. It’s a small quibble, but my concern is that the opening of the GEM will lead still more Chinese companies to divert time and resources away from building their profits and market share and instead devote energy and cash towards going public. The smaller the company, the more potentially harmful this diversion of attention can be.

China is, to use a military analogy, a “target-rich environment”. Companies often have more opportunities than they have time or resources. This is the product of an economy growing very strongly (8% this year) and modernizing at lightning speed. Large companies can also suffer when they shift focus from gaining customers to gaining a public listing. But, they will usually operate in an established market with established customers. This gives them more of a cushion.

Smaller, high-tech companies don’t have as much leeway. For these companies (last year’s revenues under $5o million) the risk is that the time-consuming and expensive process of planning an IPO on GEM will severely impact current operations, causing it to miss chances to expand, and so lose out to better-focused competitors.

In other words, there’s a trade-off here that tends to get overlooked in all the excitement about the opening of this new stock market in China. The trade-off is between focusing on capital-raising and focusing on building your business.

In my experience, private Chinese companies are already often a little too fixated on an IPO. It’s the main reason so many have made the poor, and often fatal, choice to go public on the American OTCBB. The GEM, I fear, will add fuel to this fire. Often, the best choice for a fast-growing private Chinese company will be to ignore the many pitches they’ll hear from advisors to IPO, and hunker down by focusing on their business for the next year or two.

Yes, being a boot-strapped company is tough. There’s never enough cash around. I know this at first-hand, since along with running China First Capital, I’m also CEO of a boot-strapped security software company in California, Awareness Technologies. Our growth opportunities far exceed our ability to finance them. So, I can understand why the thought of raising an “easy” $5 million – $15 million by going public on the GEM is very attractive to any Chinese boss running a similar cash-short and opportunity-rich company.

But, capital always has a cost. In this case, the main costs will be both the cash paid to advisors and regulators, along with the indirect cost of being a beat slower to seize available opportunities to grow. In China at the moment, any slowness is not just a problem. It can be life-threatening. Every business here operates in a hyper-competitive marketplace.

Of course, any company that can raise money by going public on the GEM will eventually enjoy a big advantage over competitors. It will have the cash and the stronger balance sheet to finance growth. But, the IPO process in China remains far slower than in the US or Hong Kong. A company planning and funding its GEM IPO now, may need to wait two years or more to get all necessary approvals and so finally raise that money with an IPO. Meantime, competitors are, as Americans like to say, eating this company’s lunch.

It’s a discussion we often have with SME bosses – how to time optimally an IPO. A rule of thumb with IPOs is: “small is not beautiful.” Going public on the strength of still limited earnings and revenues will likely result in a small market cap. This can adversely affect share price performance, and so limit the company’s ability to raise additional equity capital. To avoid this trap, it’s often going to be better to wait. Let competitors get bogged down in IPO planning. You can then grow at their expense.

In one way, though, the establishment of the GEM market is an unqualified triumph. It sends the signal far and wide that private SME companies will play an ever larger role in fueling the growth of China’s economy.

.

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

.

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

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

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

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

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

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

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

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

.

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

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

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

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

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

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

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

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

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

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

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

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

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

.

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

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

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

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

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

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

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

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

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

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

.

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

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

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

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

COMPANY 1

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

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

COMPANY 2

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

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

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

 COMPANY 3

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

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

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

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

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

.

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

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

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

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

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

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

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

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

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

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

.

In an interesting discussion this week in Shenzhen with a very smart and capable lawyer (Ke Luo of Fangda Partners), I learned about a small, but growing backlash against the Top Tier private equity firms working China. Evidently there have been some articles in the Chinese press voicing criticisms of their approach and methods, and comparing them unfavorably with Chinese domestic investment companies. 

Upfront disclosure: we choose to work only with the 70 or so Top Tier private equity firms active in China, as we believe they are the best investors for companies with the greatest potential, adding more value, beyond just capital, than any other source of investment. 

A main point of contention: the ratchet and performance provisions of most of the top private equity investment deals in China (and everywhere else in the world). These are the provisions, incorporated into the final closing share purchase agreement, through which the PE firm gains greater ownership in a company they’ve invested in if the company fails to meet previously agreed revenue, profit or margin targets.   

It’s a penalty for underperformance. And a very effective and focusing one. It’s not uncommon for these ratchets provisions to specify that the PE firm can gain an additional 10-15% ownership, at no additional cost,  in a company that fails to meet the annual targets. 

In good economic times and in solidly-run companies, ratchet provisions are very rarely put into effect. So, they are a generally just a ghoulish contingent presence in every PE investment contract, the stick that compliments the carrot of a PE firm investing in your business. I know from personal experience that the concept can seem very off-putting – even frightening – to some Chinese bosses: that the PE firm will, for example, go from owning 25% of his company to 40% of his company if the owner has one year that falls below the projected levels of profit and revenue. 

We’re not in good economic times at the moment, so it’s a certainty that more ratchet provisions will be triggered this year. This is what is behind some of the complaining in the Chinese press about international PE firms. Chinese investment firms apparently don’t often include ratchet provisions. The implication of the articles is that a Chinese company is better off taking money from a Chinese investment company, and so free itself from the possibility of a sort of “takeover by stealth”, as the PE firm’s ownership ratchets upward with each year of under-target performance. 

On the surface, ratchet provisions are a very fat, very easy target. So, no surprise some in the Chinese press are attacking them. But, it’s a very incomplete, unfair – and even financially illiterate – criticism to say that because of performance ratchet provisions, a Chinese company is better off taking money from a Chinese investment company. 

Chinese investment firms may not use performance ratchets, but they have a variety of other serious weaknesses. Believe me, I’m no fan of ratchets of any kind, and work hard in negotiations with PE firms to eliminate their potential for causing harm to our clients’ businesses.  But, I still think, in almost all cases, a good Chinese private company is far better off taking money from a reputable PE firm than from a more loosely-run Chinese investment business. 

The reasons are many. But, the most deep-seated are based on an appreciation of what an outside investor can and should provide a strong Chinese SME company besides just capital. Money, famously, all spends the same. So, taking $10mn from a rich uncle or from a leading private equity firm is no different, in terms of what the money can buy – a new factory perhaps, or expanded marketing and sales, or an acquisition. 

The key difference is that the best PE firms are going to do a lot more than just write a check and then wait for the riches to flow three years later at IPO. They are going to get deeply involved assisting the company to improve all areas of its operations, implementing best practices in areas like financial accounting and corporate governance, as well as providing real expertise on hard core sales and operational issues. They also know, from past successful experience, how best to guide a private company towards a successful IPO, whether on China’s domestic stock market, or abroad.

A Chinese investment company, from what I can gather, does not have the experience, the management talent – or even the inclination – to be involved in such a detailed fashion with the companies it invests in. 

I believe, based on my own practical experience,  that the good PE firms often really do make a significant difference inside a company, enabling it to get further faster than it otherwise would. Of course, PE firms can be a pain to work with. This goes way beyond the potential for a ratchet provision to be triggered. The good PE firms act as fiduciaries for their Limited Partners, and so require a massive amount of due diligence before investing, and no less enormous information flows (generally on financial performance) after an investment is made. They want quarterly board meetings, and often hold veto rights on any spending above $500,000 or so. 

But, in return, the PE firm will go to the furthest limits of its collective abilities to make sure the Chinese company succeeds above and beyond even what the boss of that company could expect. A domestic Chinese investment company? Most likely, they have had little experience with leading good companies toward successful IPOs, little operational knowledge, little desire to commit so thoroughly to adding value inside a company. 

So, yes, performance ratchet provisions are nasty. However, they should never come into effect – if the company and the PE firm are doing everything in their power to keep the business growing. The PE firms, contrary to the way it may appear, do not  want performance ratchets triggered any more than the company’s owner does. It’s also going to reflect badly on the PE firm’s judgment and abilities, and so make it harder for them to continue to raise money for future investment.

In other words, every time a performance ratchet is triggered, it gets harder for that PE firm to continue to thrive. They would rather own a smaller share of a solid company that’s meeting its targets, than a bigger share of one that isn’t.