China Private Equity

Making things in China is cheap. Buying things in China is not.

People living elsewhere, or ones like me who move here, will be rather surprised  to find out how expensive prices are for many of the more familiar brand-name products on sale in China. At current exchange rate of 6.78 renminbi to the dollar, many goods and services in China are sold at prices similar to the US.

Years ago, the Economist came up with their “Big Mac Index” as a way to measure real exchange rates. In their most recent survey, the renminbi looks 48% undervalued, because a Big Mac costs $1.95 in China, compared to $3.73 in the USA.

Source: The Economist

Of course, those prices tell only part of the story. Chinese wages are about 1/15^th America’s. So, while it takes an average working American about ten minutes to earn the money to buy a Big Mac, in China, a reasonably well-paid office worker would need to toil about about four times as long to earn the Rmb 13 needed to buy a Big Mac. By this measure, the price of a Big Mac in China, to truly equal the price in the US, should be about 33 cents, and therefore the exchange rate should be over Rmb35 to the dollar.

Of course, the renminbi is never going to get that low. In fact, the overwhelming likelihood is that renminbi will get much stronger than the current rate of 6.78 to the dollar. Upward pressure comes from China’s $2 trillion in foreign exchange reserves and large balance of trade surplus with the US. As the renminbi rises in value, the prices of many goods in China will become even higher, when translated into dollars, than those in the US.

How expensive are things in China? To find out, I did a little comparison shopping at the Wal-Mart closest to my office in Shenzhen. As in the US, Wal-Mart in China is highly successful, and got that way by offering “low everyday prices”. Considering the big gap in income levels between US and China, it would be a fair assumption that prices at Wal-Mart in China would be appreciably lower than those at Wal-Mart in the US.

But, that assumption would be wrong, for the most part. Here’s a rundown of prices on some popular branded products at my local Shenzhen Wal-Mart — prices below are in renminbi and current dollar equivalent at prevailing exchange rate. Quite a few are Procter & Gamble products. P&G are very strong in China, and its products are often market leaders. As in the US, P&G enjoys a close relationship with Wal-Mart.

Source: Peter’s Shopping

A few days after my visit to Wal-Mart in Shenzhen I flew to New York on business. In between meetings, I did some comparison shopping. 

Wal-Mart is the largest retailer in the US, but does not have any stores in New York. One reason is New York City’s unfriendly labor laws that would make it hard for Wal-Mart to operate in New York without unionized workers. Instead, I checked prices at local Food Emporium supermarket, Walgreens and CVS. 

While there are some pretty good deals in China, for example Heinz Ketchup and Coke, most things on the list are in line with prices in the US.  In other words, they do not reflect the vast differences in average earnings and therefore purchasing power.

Chinese workers manufacture wholesale, but buy retail.

Prices in China are high, in part, because there is a VAT of 13% on most things. More important, retailing in China is not nearly as efficient as it is in the US. While Wal-Mart is successful in China, it doesn’t enjoy anything like the market share it does in the US. Smaller, but my guess is, far more profitable. Wal-Mart faces very limited low-price competition in China. Most stores are of the Mom-and-Pop variety, which keeps overall prices high. Urban real estate is also expensive, and that also has an underlying impact on consumer prices.

In China, it’s easier to make money selling than manufacturing. Retail margins are higher and less squeezed than they are in the US. This will likely be true for many years to come. For Chinese consumers, especially the +40% who live in cities, they will likely continue to pay prices on par with those in the US, while earning appreciably less.

Xinjiang is a big place, with a land mass the size of Western Europe. It occupies 1/6^th of China’s territory, yet contributes only 1.5% of its population. I think I now know why it’s so empty. All that space must be devoted to growing Hami Melons.

This fruit is Xinjiang’s most popular export to the rest of China. It’s high season now. Even here in Shenzhen, as far as one can travel from the melon-growing precints near the Gobi Desert in Xinjiang, the large Hami melons are pervasive – in fruit stores, supermarkets, pushcarts. You can also find them piled high on many streets all over the city, with each Hami hoard minded by a guy from Xinjiang with a long sharp knife and a small scale.

The melons are generally oval-shaped and weigh about 10 pounds each. I’ve bought segments of ones weighing twice that. The most popular way to eat the melon is as a snack on the street. A tall thin slice on a wooden skewer sells for Rmb 1.

For those who haven’t had the pleasure, a Hami tastes a lot like cantaloupe, but the flesh is much crunchier, almost like an apple’s.

This time of year, across China, Hami crowds every other fruit out of the marketplace. I can’t find any statistics on Xinjiang’s total production, but my guess would be it runs to the millions of tons. Imagine the logistics: a market of 1.4 billion all simultaneously ravenous for your perishable product, grown on the fringe of a desert in one of the most distant, infrastructure-starved corners of the country.

Just to supply the Chinese market must occupy the full-time summertime efforts of tens of thousands of farmers, packers, and shippers. The melons are grown, boxed and then shipped by road and rail to every corner of China. It seems like for every 100 melons exported from Xinjiang, one local Uighur must accompany the shipment, to run the impromptu sidewalk stalls selling the fruit.

If other parts of China also grow the melon, I’m not aware of it. To find buyers, they would probably have to falsely label their melons as coming from Xinjiang. In China, Hami belongs to Xinjiang the way champagne belongs to the Champagne region of northern France.

Shenzhen probably has a larger market for Hami, on average, than many other parts of China. It’s a rich city, and Hami melon is not cheap. Bought by the kilo, the price runs to around Rmb8 to Rmb 12, or about 70-90 cents a pound. I’m buying around 10 kilos a week.

You can also find Hami this time of year in Los Angeles, usually at Persian grocery stores. Parts of Southern California’s desert are similar to Xinjiang’s Hami growing region. But, the fruit is very much a minority taste in the US. It’s likely to remain that way. As big as it is, Xinjiang will never be able produce enough Hami to satisfy fully Chinese tastes, let alone an export market.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“Five years ago, all I had to worry about was producing enough to earn a small profit. Now I spend time dealing with employment issues, environmental regulations, tax policies, trying to increase market share and staying ahead of competitors. The pressure is much worse. ”

Welcome to the suddenly changed and increasingly pressured world of Chinese corporate management. 

This comment comes from the boss of a large, integrated chemical factory in Shandong. He and I were talking recently. He is still a relatively young guy of around 40. But, in his 15 year career as first an engineer, then a manager and finally as factory boss, he has seen the purpose, methods, scope, goals and responsibilities of Chinese management change from top to bottom. 

Like much else in China, company management has undergone a lifetime’s worth of change in a matter of a few years. It’s a byproduct of larger forces at work in China’s economy – the withdrawal of direct state planning and control, the ascendancy of the private sector, China’s entry to the WTO and the opening of China’s markets to imports, the rise of a vibrant consumer market. All of these have made planning and decision-making far more intricate and the stakes far higher for Chinese corporate managers, both in state-owned and private companies. 

In the case of my friend in Shandong, he is working for a company majority owned by the state. In theory, that should make his management tasks far easier. In most cases, the Chinese government – whether at national, provincial or local level – is a very lenient shareholder. In fact, they would appear to the ideal owner for any manager who is looking for easy ride. 

In China as elsewhere, when the state is the owner, no one is really in charge. The Chinese government is not looking for dividends. Most profits stay inside the company.  

Here’s the paradox that Chinese managers all live with: as undemanding as the Chinese government is as a shareholder, they are increasingly demanding as a regulator and law-maker. That is a big reason why corporate management has gotten so much more complex in China. In a short space of time, China has gone from a more laissez-faire stance to one with strict environmental, tax and labor laws that rival those of the US and Western Europe. 

True, these tougher regulations are not yet universally applied or enforced. But, any Chinese manager who chooses to act in total disregard of these rules will eventually find himself in deep, deep trouble. Take labor laws. China continues to introduce new forms of workplace protection that give important new rights to hired staff and restrict the prerogatives of management. Any Chinese with a complaint over pay or conditions can complain directly to the Laodong Ju, or Labor Bureau, a quasi-state body that enforces labor laws. 

The process is not without its hiccups. Management can still intimidate and threaten workers who seek redress. But, the system does work. 

Example: a friend of mine worked for several years as a salesperson for an electronics company based in Shenzhen. She was paid part in commission. She did her job well. For months, then years, the boss held back the commission payments, claiming cash flow problems. This is old style China management: don’t pay, offer excuses. This boss assumed he could continue indefinitely with this trickery, in part because the general view is that female workers in China are more easily cowed or mollified. 

Instead, my friend quit without warning,  went right to the Labor Bureau, which made one call to her ex-boss. No investigation. Just a phone call and a stern warning from the Labor Bureau. My friend got her money – about $20,000 in total – within a week. The boss will now have a much harder time doing what he’s always done – pad his own take-home by cheating workers out of what they are entitled to. Tyrannizing workers is no longer a workable HR strategy for a Chinese management team. 

New environmental rules are, if anything,  even more disruptive of old lax ways of managing business in China. Managers who choose to improve margins by ignoring pollution standards are risking an early unpaid retirement. Example: a client of ours is the leading environmentally-friendly paper manufacturer in Shandong. Two years ago, he had 29 competitors in Shandong. Today, he has only three. 

The other 26 were shut down, virtually overnight, for violating environmental standards. The managers at those factories, most of which were around for many years, now likely understand better than most how much the craft of management has changed in China.  

Elsewhere in Shandong, my friend the chemical company boss, is now making another decision that was unimaginable when he began his career: he is working on a plan for a management buyout of the factory. The business is now 65%-owned by a large local coal mine, which in turn, is owned by the provincial government. 

The buy-out plan is still in its early stages. To succeed, he’ll need to persuade several levels of government – no one is quite sure how many – and also take over some significant liabilities, including debts of about $15mn.  It’s not clear if the current management will need to put up cash to buy the government’s controlling stake, or if, as preferred, they can pay in installments, using cash from the business. 

Servicing debt and having most of one’s wealth tied up in illiquid shares of one’s company are other adaptations now being learned by Chinese management. Each year, their working lives grow harder, more pressured and, for the more talented and nimble ones, far more financially rewarding.  Stride-for-stride with the modernization of China’s economy, Chinese corporate managers have gotten better faster than anywhere else, ever.

Shenzhen’s Stock Exchange was the world’s busiest and largest IPO market during the first half of 2010. Through the end of June, 161 firms raised $22.6 billion in IPOs on Shenzhen Stock Exchange. The Shanghai Stock Exchange ranked No.4, with 11 firms raising $8.2 billion.

Take a minute to let that sink in. The Shenzhen Stock Exchange, which two years ago wasn’t even among the five largest in Asia, is now host to more new capital-raising transactions than any other stock market, including Nasdaq and NYSE. Even amid the weekly torrent of positive economic statistics from China, this one does stand out. For one thing, Shenzhen’s Stock Exchange is effectively closed to all investors from outside China. So, all those IPO deals, and the capital raised so far in 2010, were done for domestic Chinese companies using money from domestic Chinese investors.

The same goes for IPOs done on Shenzhen’s larger domestic competitor, the Shanghai Stock Exchange. In the first half of 2010, the Shanghai bourse had eleven IPOs, and raised $8.2 billion. That brings the total during the first half of 2010 in China to 172 IPOs, raising $31 billion in capital.

The total for the second half of 2010 is certain to be larger, and Shenzhen will likely lose pole position to Shanghai. The Agricultural Bank of China just completed its IPO and raised $19.2 billion in a dual listing on Shanghai and Hong Kong exchanges. Over $8.5 billion was raised from the Shanghai portion.

One reason for the sudden surge of IPOs in Shenzhen was the opening in October 2009 of a new subsidiary board, the 创业板, or Chinext market. Its purpose is to allow smaller, mainly private companies to access capital markets. Before Chinext, about the only Chinese companies that could IPO in China were ones with some degree of state ownership. Chinext changed that. There is a significant backlog of several hundred companies waiting for approval to go public on Chinext.

So far this year, 57 companies have had IPOs on Chinext. The total market value of all 93 companies listed on Chinext is about Rmb 300 billion, or 5.5% of total market capitalization of the Shenzhen Stock Exchange. On Shenzhen’s two other boards for larger-cap companies, 197 companies had IPOs during the first half of 2010.

The surge in IPO activity in China during the first half of 2010 coincided with the dismal performance overall of shares traded on the Shanghai and Shenzhen stock exchanges. Both markets are down during the first half of the year: Shanghai by over 25%  and Shenzhen by 15%. 

The IPO process in China, both on Shanghai and Shenzhen markets, is very tightly controlled by China’s securities regulator, the CSRC (证监会). It’s the CSRC that decides the number and timing of IPOs in China, not market demand. One factor the CSRC gives significant weight to is the overall performance of China’s stock market. They want to control the supply of new shares, by limiting IPO transactions, to avoid additional downward pressure on share prices overall.

So, presumably, if the Chinese stock markets performed better in the first half of 2010, the number of IPOs would have been even higher. Make no mistake: the locus of the world’s IPO activity is shifting to China.

Comments don’t get any better than this one, a detailed assessment of the hazards of reverse mergers. It was added as a comment to an earlier blog post of mine. I’m grateful for the contribution, and humbled by the writer’s knowledge and clear writing style.  Highly recommended.

A Reverse Merger (”RM”) is routinely pitched as a cheaper and quicker method of going public than a traditional IPO in China. This may be technically true but the comparison is VERY MISLEADING. 

As you mentioned a few times in your blog, an RM is not a capital raising transaction. No shares are sold for cash in the transaction. It will receive little attention from analysts ! The RM is often coupled with a PIPE financing. However, the amount of PIPE financing that can be raised is very limited. Additionally, PIPE financing is typically expensive relative to other financing options and may contain onerous terms. 

Generally, completing a $50 million IPO will roughly run a company 18% of the offering proceeds, including underwriter discounts, under pricing, and legal, accounting, filing, listing, printing, and registrar fees, or $9 million. 

Conversely, an RM was advocated as “costs only between $100,000 and $400,000 to complete”. This is the most tricky and misleading part, because this cost range does not include the value of the equity stake retained by the shell promoter and its affiliates. And most Chinese company does not understand this. 

Generally when the RM closes, the Chinese Operating Company is issued Shell Company shares only equal to 80% to 90% of Shell Co’s post-merger outstanding shares. The the remaining 10% to 20% of shares are retained by the owner of the Shell Company, the promoter and its affiliates.

Hence, in addition to the $100,000 to $400,000 in cash paid by Chinese Operating Co to complete the RM, the Chinese Operating Co has also “paid” a 10% to 20% stake in its company. If the market capitalization is $50 million post-RM, this stake is worth $5 to $10 million. 

So RM is not cheaper at all ! It is Usually an option for second and third tier companies to obtain financing via a PIPE, and Some PIPE investors may not be long-term investors. An active trading market for stock may not be developed through a RM. Company will probably not qualify to trade on the Nasdaq and will likely end up trading in the pink sheets or the bulletin board. 

Congratulations to Kleiner Perkins Caufield & Byers on the successful NASDAQ IPO of its portfolio company AutoNavi, a Chinese mapping company that supplies maps for GPS navigation systems. KP owned 4.3% of the company prior to its recent IPO. At time of IPO, Kleiner owned 6,527,520 ordinary shares of AutoNavi, now worth around $25mn. That equates to a 2.5X rate of return over the four years KP held the investment.

The AutoNavi investment was made by KP’s main office in California, not Kleiner Perkins China, which was set up in 2007 to lead the US firm’s investing activities in China, and is still waiting for its first exit. According to KP China’s website , the AutoNavi investment is managed by KP China.

Two other venture capital firms also held AutoNavi shares at the time of IP, Walden International and Sequoia.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

I don’t know the direction of the dollar-renmibi exchange rate. But, I do know most of the American press, led by the New York Times and Washington Post, got snowed by the announcement last weekend that China would introduce new “flexibility” in its exchange rate.

The immediate media reaction – and that of the Obama administration – was one of hosannas and smug approval. The tone of most coverage was along the lines, “the Chinese have finally seen the error in their mercantilist ways and will now allow their currency to appreciate strongly against the dollar, leading to a new golden age of manufacturing employment in the US.”

A week has gone by and the renminbi has appreciated by exactly 0.5%.  So, a $100 item made in China that previously cost Rmb682 will now cost an importer Rmb685, or $100.50. Factory managers in the US may be waiting for awhile yet before the flood of orders arrives from China.  The President’s union buddies will also not soon see much of an uptick in their membership rolls.

For those without short-term memory impairment, this is, of course, the second time in two months that US press and the Obama administration loudly predicted the imminent upward revaluation of the renminbi. In April, a flurry of reporting, loudest and strongest from the New York Times,  announced the Chinese government was at last ready to accede to US demands and let the renminbi rise.

That time, the press articles were timed to coincide with a visit by the US Secretary of Treasury, Timothy Geithner, to Beijing. He was there, if the Administration and its media allies were to be believed, to talk tough and get the Chinese to fall in line with American wishes. Discernible results? Zero.

This time around, the reporting coincides with the G-20 Summit meeting in Toronto, where we are told, President Obama will use his intelligence and oratorical brilliance to persuade Chinese leader Hu Jintao to do his part for the sagging US economy. Likely results? We’ll see, but the signs are that China will continue to make policy decisions with its own interests to the fore.

There is much both wrong and economically illiterate about all this US pressure to revalue the renminbi. Start with the fact the Chinese currency is not significantly undervalued. Yes, it is tied to the dollar. So are many other currencies with which the US trades, including Mexico, Taiwan, Russia, Singapore, Thailand, Saudi Arabia. The renminbi’s formal peg with the dollar ended in July 2005. It is true that the renminbi, if it were fully convertible and freely floating, would likely appreciate against the dollar. But, by enough to really make an impact on US manufacturing employment? Hardly.

The biggest benefit to China of letting the renminbi rise against the dollar would be to lower the renminbi cost of China’s huge imports of oil, iron ore and other core dollar-denominated raw materials. Weighing against this would be falling margins at many of China’s exporters, which would ultimately have an impact on manufacturing employment.

Creating and maintaining jobs is a paramount concern for a country whose labor force grows by millions every year, and where there is no “social safety net” as in the US.  Fact: every year, six million more Chinese join the migrant labor force, according to recent report by China’s National Population and Family Planning Commission.

It’s a mistake shared by many Americans that at the current exchange rate, China is some kind of low-cost paradise for people with dollars. I live here. Prices here are not low. In fact, most things in China, with exception of fresh vegetables and public transportation, are either on par with US prices or higher.

Most fruit is generally more expensive here, even at the proletarian outdoor market where I do a lot of my shopping. Same goes for beef, chicken and most everything else you fill up a supermarket cart with. Gas, automobiles, computers, TVs, brand-name products are all higher in China than in the US.

I’m writing this in my local Starbucks in Shenzhen. And while this is hardly a perfect bellwether, the cheapest cup of regular brewed coffee here costs Rmb 15, or $2.20. A cappuccino? Rmb 25, or $3.65.  The place is jammed, as it always is, from noon to midnight. Not a seat in the house. Starbucks has over 350 stores in China and growing fast.

Not that long ago, the renminbi was pegged at 8.2 to the dollar. Has this 17% appreciation done anything to impact the decline of manufacturing employment in the US, a decline that began over 30 years ago? No. Will another 17% appreciation of the dollar reverse this trend? I very much doubt it.  Instead, what will likely happen is prices for many products in the US will rise sharply, since so much of what America likes buying is made here.  This will lead to higher unemployment, lower growth and hit hardest the poorer Americans President Obama claims to champion.

Make no mistake: if Chinese prices rise, this will not create huge new opportunities either for US manufacturers to reconquer the domestic market or allow lower wage countries like Bangladesh, Nigeria, India, the Dominican Republic or Peru to increase dramatically their exports to the US. Those countries can’t now, nor will they ever in my view, manufacture products to match the quality at the same price of those made in China, even if the cost of Chinese made products rises 15%-20% or more.

True, an economics professor’s models would argue otherwise, and President Obama is surrounded by economics professors. The models are plain wrong. Some textile imports from places other than China will rise. Not much else.

So, the real world result of the “strong renminbi” policy: greater economic hardship in the US.  But, won’t ordinary Chinese benefit from lower import prices? Perhaps a little, but not in any way that will create the desired outcome of much higher manufacturing employment and exports in the US. Maybe the Washington state apples and cherries in my supermarket will become a little cheaper, and become only twice as expensive as they are in the US. Again, not overly likely.

China’s current currency policy has its benefits and drawbacks. The benefit is mainly greater predictability for exporters, which has been somewhat helpful during the economic crisis of the last two years in China’s largest export markets of the US and Europe. Even with the stable exchange rate, a lot of exporters in China went bankrupt over this period, because of a collapse in orders from the US and Europe.

The biggest drawback of current exchange rate policy: $3 trillion in foreign exchange reserves accumulated to soak up all the dollars still pouring into the country. This money is not being put to any direct productive use to improve China’s economy. A higher renminbi will not alter that calculus much, if at all.

I’m troubled in many ways by the direction of American international financial policy. The Obama Administration finds it far easier to scapegoat China’s exchange rate than put their focus on the deepest source of American economic malaise: runaway spending and budget deficits in Washington, with the inevitability of large tax increases to follow.

It’s not likely to happen, but here’s what I’d most like to see is the next time the US media starts braying for a higher renminbi. Chinese newspapers respond with articles, quoting unnamed Chinese government officials,  pleading with the Obama Administration to cut spending, deficits and taxes, and so put more money in the pockets of American consumers. They will certainly choose to spend some of this cash on Chinese-made products and so help boost employment, wages and living standards across China.

As panaceas go, this one would be a lot more effective and all-around helpful than anything the American government and its media allies are peddling.

Anyone who has enjoyed Chinese food in China will discover, by aroma as well as by taste, that garlic is the most widely-used flavoring agent of all, after salt. It’s detectable – in fact visible – in just about every stir-fried or stewed dish, in such large quantities to leave most outsiders breathless. Which, of course, is just as well. 

A simple stir-fried dish will often have 3-4 whole cloves of chopped or sliced garlic. Many dishes have far more. One of my favorites, Lazi Jiding, is a Sichuan dish of small chunks of chicken, chili peppers, and often several heads’ worth of garlic cloves all deep-fried together.

Garlic turns up everywhere, at all times of the day. This morning at the breakfast buffet of the hotel where I was staying in Fujian, there was a dish of simple stir-fried cabbage that had at least 25 cloves of garlic in it. I stopped counting long enough to spoon some onto my plate, and move onto the next garlic-laced Chinese breakfast treat.  

I lived a lot in Italy,  the other country famed for its use of garlic. There, adding more than one clove to a dish is usually considered excessive, even uncouth. You will likely eat more garlic in a day in China than a month spent eating in Italy. 

In the US, garlic has become a far more common part of the diet than when I was a child.  I began noticing several years ago that all the garlic I bought in LA was imported from China. That always struck me as odd, since very little fresh food is imported from China, and California has a town, Gilroy, that’s famed as one of the world’s largest producers of garlic. 

The Made-in-China garlic I’ve bought is always fresh, crisp and cheap – usually no more than a dollar a pound. I never figured out how anyone could make any money shipping it from so far and selling it for so cheap. 

I assumed that the US’s ever-increasing appetite for garlic was emptying China of its favorite flavoring. Since moving to China, however, I’ve seen that wasn’t the case, that there was more than enough to satisfy China’s far larger appetite. So, then my question became: where is all this garlic being produced? From all the garlic in circulation, you’d think half of China’s arable land must be used to cultivate it. Yet, I’ve never seen any in the ground. I’ve asked friends, farmers, chefs, but never got a clear answer to where all this garlic was coming from. 

Now I know at least one place. Jinxiang County in Shandong Province is the largest garlic-producing area in China. This little-known area in Shandong’s southwest corner is not far from Qufu, Confucius’s birthplace. Jinxiang  is also now one of the centers of worldwide commodity speculation. The price of Jinxiang-grown garlic has spiked recently, rising more than fifty-fold from its low a year ago. As the China Daily reports, “Garlic trading has created a handful of new millionaires overnight in Jinxiang county.” 

I couldn’t find a figure for Jinxiang’s total garlic output. But, last year Jinxiang produced 70% of China’s garlic for export, over one million tons last year. That means that Jinxiang produced half all the garlic eaten outside China. At current pace and current export price of around $1,000 a ton, Shandong will export over $1 billion of garlic in next 12 months. 

China has no strong natural advantage in garlic-production. It’s not particularly labor-intensive, nor does it grow best in climate like China’s. Garlic, after all, is a member of the onion family, and so grows pretty well all over the world. Jinxiang must be the world’s leading garlic producer for other reasons that highlight a part of China’s economic strength that is often not emphasized: regions with intensive focus on particular industries (in this case, growing garlic for home and export market)  and a developed infrastructure to move goods quickly and efficiently to market. 

China has one other advantage that helps explain its dominance in global garlic-production. The whole plant can be sold for good money, not just the bulb. Chinese also eat prodigious quantities of the green garlic shoots that grow above ground. This vegetable, called jiu cai （韭菜）in Chinese, is served on its own, as a stir-fried dish, or added to many other staples, including dumplings. Like a skilful butcher carving a hog,  garlic farmers in Jinxiang know how to extract every morsel of profit, and leave nothing to waste. 

I’m determined now to go to Jinxiang. Partly, it’s because I love garlic. But, I also want to see (and smell) this region for myself, how farms are organized, what else is grown or manufactured there. I want to find out more how one place became so big and so successful selling one agricultural product that (unlike, say, tobacco or ginseng) grows just about anywhere. 

My company is lucky enough to have two clients in Shandong. I’ve already worked out how far these companies are from Jinxiang, and will go there at first opportunity.  I’m pretty certain over the last 20 years, to satiate my love of garlic, more of my money has ended up in Jinxiang than just about anywhere else in China.  

Just about everyone has experienced a miraculous coincidence at least once in their lifetime, a chance encounter with a friend at a place and time where neither side would ever have expected to meet. I’ve had a few in my life. The most memorable was running into Giovanna, an old girlfriend of mine from when I was a graduate student at the Chinese University of Hong Kong. I literally bumped into her, eight years after losing touch (this was in the pre-email era) one morning at the bustlingly gorgeous Campo de’ Fiori vegetable market in the center of Rome.

We quickly got reacquainted, and she juggled me and her then-current boyfriend for awhile. I was a foreign correspondent for Forbes based in London. She was living in Rome, close to the market, one of my favorite spots in one of my favorite and most-visited cities in the world.

There was a high degree of improbability about that meeting in Rome. But, it wasn’t completely unfathomable, since she was an Italian, and even when I knew her, interested in film-making. Rome is the center of that industry in Italy. Giovanna had studied in China, spoke good Chinese and had landed a small job helping Bernardo Bertolucci shoot scenes in China for “The Last Emperor”.  She parlayed that into a friendship with the director and the producer of Last Emperor, and then found other work in the film business.

In Chengdu recently, I had an even more remarkable coincidental meeting than that one in Campo de’ Fiori. At a large and fancy restaurant there, a friend of mine from work, Nick Shao, who is a Managing Director of PE firm Carlyle in Shanghai, came up and greeted me as I sat down at a table with two people I only just met.

My brain circuitry is not what it used to be. It probably took me two to three seconds to actually figure out who Nick was and how I knew him. Then it clicked, of course, and I started burbling in my bad Chinese about how remarkable the whole thing was – why was he there? Doing what? Was the food any good?

Running into Nick was remarkable for a lot of reasons, including the fact I know a comparatively small number of people in China, had not been in Chengdu in 28 years, and was in a restaurant that seats at least 800 people. To end up at a table nearby to someone I knew, in a city of 11 million that neither of us have any connection to, in a country with the largest population in the world, that’s a level of unlikelihood that I can’t even begin to quantify. I’d be hard-pressed to find one of my own family members in that restaurant, it’s that large and crowded.

As I found out, Nick was in Chengdu for an EMBA course he’s taking. This also left me a little nonplussed, since I knew Nick already had an MBA from Columbia. Why would anyone need two? Why was his Shanghai university convening its class at a not-especially famous restaurant in Chengdu? I still don’t have solid answers to either of these questions, even after exchanging emails with Nick later that day.

For my part, I was in Chengdu to participate in a PE conference organized by the Sichuan government. I skipped the official lunch to meet some friends-of-friends. It would not be stretching things to say the last place I’d expect to meet someone I know would be that restaurant, in that city, in that country, at that date and time.

I had a great three days in Chengdu,  eating, chatting and walking around China’s most relaxed, pleasant and livable major city. Meeting Nick made it very much more memorable, just as I continue to remember, when I think of Rome, that meeting, over 20 years ago, in Campo de’ Fiori.

For me, at least, this coincidental meeting spurred a lot of what little I can muster in terms of philosophical reflection. It’s all hackneyed stuff, of course, but our lives really are created by the miracle of birth, and punctuated thereafter by occasional miracles, large and small. The world is, in its most benign state, the motive force for the coming true of every sort of wonderful, unexpected but thoroughly delightful possibility. Dreams come true. Happy coincidences occur.

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My career has come full circle. I’m back at Forbes Magazine. Only this time, I’m published in the magazine’s Chinese website, as an occasional columnist.

Have a look here: http://www.forbeschina.com/review/201005/0000757.shtml 

I was at Forbes for almost ten years, and left in 1995, after writing I’d guess around 120 articles, first in New York, and then in Europe, based in London.  I had a splendidly enjoyable career at Forbes, traveling farther and wider than I ever dreamed possible, while writing about companies, ideas and events that seized my interest, and that of my editors at Forbes. I had the great good fortune to be at Forbes while it was edited by Jim Michaels, perhaps the finest ever editor of a business publication.  Read about him by clicking here. 

After leaving Forbes, I always told friends I was much happier outside journalism. I never looked back, never hankered for even a day to get back into journalism. There’s some truth, at least when applied to me, that it’s more rewarding to try to make a little history, rather than to write about those who do. 

All the same, it’s a special feeling to see my byline on the Forbes Chinese website. I accepted immediately when the magazine called to see if they could publish Chinese versions of my blog posts. I’m not all that sure how successful, if at all, Forbes is in China. So, my columns may have a smaller readership than some of the Chinese-language SMS messages I send. 

This time around at Forbes, my writing won’t go under the knife of a sharp team of editors and wordsmiths. Back then, I railed frequently, and impotently, against what I saw to be the boneheaded or misguided changes imposed from above.

Now, well, I have to acknowledge my work could probably benefit from some editing and intervention. Chinese is not a language I speak with much skill. Writing it far harder still. I rely on lots of assistance from my smart co-workers to transubstantiate my hot air  into solid Chinese. 

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

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

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

A few of the takeaway points are:

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

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

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

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

No firm in the venture capital industry can match the reputation, global influence and swagger of Kleiner Perkins Caufield & Byers (“KP”). KP is accustomed to outsized success and glory  – which makes the lackluster performance of KP’s China operation all the more baffling. For all its Midas-touch reputation in Silicon Valley, KP’s China operation looks more like 100% pyrite. It seems beset by some poor investment choices, setbacks and even rancor among its partners and team. The firm’s Chinese-language website even manages to misspell the Kleiner Perkins name. (See below.)

Two years ago, Joe Zhou, one of the founding managing partners of KP in China left the firm to set up a rival VC shop, Keytone Ventures. Two other KP partners in China have also left. Losing so many of its partners in such a short time is an unprecedented occurrence at KP — even more so that two of these partners left KP to set up rival VC firms in China.

A partnership at KP is considered among the ultimate achievements in the business world. Al Gore took up a partnership at KP in 2007, after serving as Vice President for eight years and then losing the presidential election in 2000. Colin Powell also later joined the firm, as a “Strategic Limited Partner”.

Joe Zhou left KP just 13 months after joining. When he left, he also took some of the senior KP staff in China with him. Zhou also negotiated to buy out the portfolio of China investments he and his team had overseen at KP China. They paid cost, according to someone directly involved in the transaction. In other words, KP sold its positions in these investments at a 0% gain. Factor in the cost of that capital, and the portfolio was offloaded at a loss.

This isn’t going to endear KP to the Limited Partners whose money it invests.  It also signals how little confidence KP had in the future value of these China investments the firm made. Other top VCs and PEs are earning compounded annual rates of return of +50% in China.

There was every reason to believe that KP would achieve great success when it opened in China in 2007. Indeed, when KP opened its China office, it issued a celebratory press release, titled “Kleiner Perkins Caufield & Byers Goes Global;Joe Zhou and Tina Ju to Launch KPCB China”.

Along with having the most respected brand in the VC industry, KP arguably has more accumulated and referenceable knowledge than any other VC firm on where to invest, how best to nurture young companies into global leaders. It’s roster of successful investments includes many of the most successful technology companies in history, including: Amazon, AOL, Sun, Genentech, Electronic Arts, Intuit, Macromedia and Google.

Opening in China was KP’s first major move outside the US – indeed, its first move outside its base in Silicon Valley. KP has only three offices in total, one in Menlo Park , California and one each in Shanghai and Beijing.  On its website, the firm’s China operations receive very prominent position. Two of the firm’s most renowned and respected partners, John Doerr and Ted Schlein, apparently played an active part in KP’s entry into China. Along with the high-level backing, KP also raised over $300mn in new capital especially for its China operations. One can assume KP has already taken over $15mn in management fees for itself out of that capital.

Beyond the capital and high-level backing, KP also prides itself on being better than all others in the VC world at building successful companies. So, it’s more than a little surprising that KP’s own business in China has so far failed to excel, failed even to make much of an imprint. Physician heal thyself?

I’m in no way privy to what’s going on at KP in China, and thus far have not had any direct dealings with them. I’ve always admired the firm, and fully expect the China operation to flourish eventually. For one thing, great entrepreneurs and good investment opportunities in China are just too numerous. A firm with KP’s deal flow, capital and experience should find abundant opportunities to make significant returns investing in IPO-bound businesses.

From the beginning, KP’s operation was  a kind of outsourced operation. Rather than sending over partners from KP in the US, the firm instead hired away from other firms partners at other China-based VCs. While this meant KP could ramp up in China more quickly, it also put the firm’s stellar reputation, as well as its capital, in the hands of people with no direct experience working at the firm.

The KP website lists 14 companies in the China portfolio. The portfolio is very heavily weighted towards biotech, cleantech and computer technology, mirroring KP’s focus in the US. Other tech—focused VCs in China have run into trouble, and are now shifting much of their investment activity towards established Chinese SME in more traditional industries. In the best cases, these SME have strong brands and very robust sales growth in China’s domestic market.

In my view, investing in these SME offers the best risk-adjusted return of any PE or VC investing in the world right now. KP has yet to make the shift. I wish KP nothing but success, and hope for opportunities in the future to work with them. Its technology bets in China may pay off big-time, in due course. But, meantime, KP is in the very unaccustomed position of laggard, rather than leader, here in China.

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It’s surely embarrassing, if not emblematic, that the home page of the Chinese-language version of KP’s own website manages to misspell the company’s name.  Check out the top-most bar on the page, where the firm is named “Kliener,  Perkins, Caufield and Buyers” .

Update: as of May 11, 2010, the Chinese version of Kleiner Perkins’ home page has been corrected.

One way or another, every good money-making idea ends up in China. But, they don’t all succeed. Possible case in point: current efforts by China’s Citic Capital Partners to create a homegrown competitor to the global private equity leaders Blackstone, TPG, KKR, Carlyle. 

These global firms started and prospered in the US at very opportune time, when many tired, poorly-managed older industrial companies were in need of shaking up.  The PE firms seized this opportunity. Though their styles and investment appetite differed somewhat, all had a similar M.O: buy a controlling stake in an existing business (or division of a larger corporation) using a slim wedge of their own equity capital and a large helpings of debt, either in the form of bank loans or bonds. They then installed new management, slimmed down bloated workforces,  tightened operations, improved cash flow and margins to pay down the bank debt, and then exited by selling the newly-fit company to someone else, or staging an IPO. 

Today’s global PE giants were all once known as Leveraged Buyout shops. The firms ditched that name in favor of the more innocent-sounding term of Private Equity about ten years ago. But, it’s the leverage that gave the global firms the keys to the kingdom, and often produced stunningly high return on equity. The math is simple. If you only put up 25% or so in cash, and then double the value of a business by improving profitability, you can earn upwards of six to eight times your original equity investment. Returns like this, and often higher, allowed the big global firms to raise well over $100 billion in the last five years, and made their founders billionaires. 

When the financial crisis struck in the summer of 2008, banks stopped supplying the debt finance. No leverage, no buyouts. The last major deal, Cerberus’s $7bn purchase of 80% of Chrysler from Daimler-Benz collapsed in 2007, with losses of over $5 billion. The big firms are still licking their wounds. The dearth of bank finance means the deals they are trying to do now require them to put up all or most of the cash themselves, without recourse to leverage. That, of course,  will put strong downward pressure on what were once very high rates of return. 

With what looks to be bad timing, a successful and well-established Chinese PE firm has now apparently decided to try to become a leader in doing buyouts in China. At first glance, leveraged buyouts look well-suited to China. There are lots of tired old industrial companies, mainly state-owned enterprises (SOEs),  that seemingly could benefit from some radical restructuring. Slice the fat away and a trimmer, profitable business could emerge. 

There are, however, a number of serious problems with this business model in China. Start with the fact that it’s generally difficult, if not impossible, to buy a controlling stake in one of these giant SOEs. If you don’t have control, you don’t have a sure way to implement any changes to improve things. Next, leverage is also unavailable to finance such deals. Third, for the most part, all the better SOEs have already gone public, leaving a rump of outcasts that no amount of restructuring could save. Fourth, arranging an exit is at best uncertain and time-consuming, and at worst, impossible, depending on the decision of China’s security regulators. 

Finally, any Chinese firm entering the buyout market now will need to compete successfully against TPG, Carlyle, Goldman Sachs, KKR and Blackstone, all of whom have long experience in the field as well as established operations in China. They are struggling to find good buyout deals in China. Too much talent and money is already chasing too few opportunities to do big buyouts in China. 

There have been a few success stories doing buyouts in China. The most notable was TPG’s purchase five years ago for Rmb 1 billion ($145 million) of 16.76% of Shenzhen Development Bank. TPG was able to exercise significant management control. They brought in an American CEO, improved the bank’s operations, and are now in the process of selling it to Pingan for over Rmb 11 billion ($1.7 billion). If the deal is approved by Chinese regulators, TPG stands to make a profit of about $1 billion, or an eleven-fold return. 

The lure of those fat returns – and probably the reputational boost that comes with pulling such deals off –  have seemingly convinced Citic Capital to focus on buyouts in China. Citic Capital launched this new strategy over a year ago, and closed its second dedicated China buyout fund, raising over $900mn,  in February of this year. Overall, Citic Capital has over $3bn under management. 

I’ve met some of the Citic Capital team, and they are all first-rate: smart and clearly able. Still, the shift in investment focus seems puzzling, at least to this outsider. 

Citic Capital Partners is the PE arm of one of China’s best banks, and a leader in providing loans to private SME. CITIC Bank could certainly continue to provide a steady source of high-quality deal flow to its PE business.  Indeed,  Citic Capital was successful and well-established doing the best kind of PE deals in China: investing $10 million – $20 million per deal to acquire a minority stake of around 20% in a fast-growing private Chinese company, then aiding that company in the process of planning for and executing a successful IPO.  

Why would Citic Capital change a winning formula? My sense is that it’s part of an effort by Citic Bank to differentiate its PE business, and establish early leadership in an area that they believe may well day prove lucrative. This may turn out to be prescient. China’s laws change often, and somewhat unpredictably – just because buyout investments are difficult today, does not mean they will always be.   

But, the problem remains that good buyout deals in China are scarce, and competitors are numerous. Buyouts are out of favor everywhere in the world, including with those who put up the money, the endowments, pension funds, family offices and other institutional investors who serve as Limited Partners. 

At this moment in financial history, and likely for quite a long while to come, the best risk-adjusted returns are available for minority PE investments in successful fast-growing Chinese SME. That’s where Citic Capital and other firms have made their reputation and made investors very good money.