I get asked occasionally by private equity firm guys how CFC gets such stellar clients. At least in one case, the answer is carved fish, or more accurately my ability quickly to identify the two murky objects (similar to the ones above) carved into the bottom of a ceramic dish. It also helped that I could identify where the dish was made and when.

From that flowed a contract to represent as exclusive investment bankers China’s largest and most valuable private GPS equipment company in a USD$30mn fund-raising. It’s in every sense a dream client. They are the most technologically adept in the domestic industry, with a deep strategic partnership with Microsoft, along with highly-efficient and high-quality manufacturing base in South China, high growth and very strong prospects as GPS sales begin to boom in China.

Since we started our work about two months ago, several big-time PE firms have practically fallen over themselves to invest in the company. It looks likely to be one of the fastest, smoothest and most enjoyable deals I’ve worked on.

No fish, no deal. I’m convinced of this. If I hadn’t correctly identified the carved fish, as well as the fact the dish was made in a kiln in the town of Longquan in Zhejiang Province during the Song Dynasty, this company would not have become our client. The first time I met the company’s founder and owner, he got up in the middle of our meeting, left the room and came back a few minutes later with a fine looking pale wooden box. He untied the cord, opened the cover and allowed me to lift out the dish.

I’d never seen it before, but still it was about as familiar as the face of an old teacher. Double fish carved into a blue-tinted celadon dish. The dish’s heavy coated clear glaze reflected the office lights back into my eyes. The fish are as sketchily carved as the pair in the picture here (from a similar dish sold at Sothebys in New York earlier this year), more an expressionist rendering than a precisely incised sculpture.

It’s something of a wonder the fish can be discerned at all. The potter needed to carve fast, in wet slippery clay that was far from an ideal medium to sink a knife into. Next came all that transparent glaze and then the dish had to get quickly into a kiln rich in carbon gas. The amount of carbon, the thickness and composition of the glaze, the minerals dissolved in the clay – all or any of these could have contributed to the slightly blue-ish tint, a slight chromatic shift from the more familiar green celadons of the Song Dynasty.

All that I knew and shared with the company’s boss, along with remarking the dish was “真了不起”, or truly exceptional. It’s the finest celadon piece I’ve seen in China. Few remain. The best surviving examples of Song celadon are in museums and private collection outside China. I’m not lucky enough to own any. But, I’ve handled dozens of Song celadons over the years, at auction previews of Chinese ceramic sales at Sotheby’s and Christie’s in London and New York. The GPS company boss had bought this one from an esteemed collector and dealer in Japan.

The boss and I are kindred spirits.  He and I both adore and collect Chinese antiques. His collection is of a quality and breadth that I never imagined existed still in China. Most antiques of any quality or value in China sadly were destroyed or lost during the turbulent 20^th century, particularly during the Cultural Revolution.

The GPS company boss began doing business in Japan ten years ago, and built his collection slowly by buying beautiful objects there, and bringing them home to China. Of course, the reason Chinese antiques ended up in Japan is also often sad to consider. They were often part of the plunder taken by Japanese soldiers during the fourteen brutal years from 1931 to 1945 when they invaded, occupied and ravaged parts of China.

Along with the celadon dish, the GPS boss has beautiful Liao, Song, Ming and Qing Dynasty porcelains, wood and stone carvings and a set of Song Dynasty paintings of Buddhist Luohan. In the last few months, I’ve spent about 20 hours at the GPS company’s headquarters. At least three-quarters of that time, including a visit this past week, was spent with the boss, in his private office, handling and admiring his antiques, and drinking fine green tea grown on a small personal plantation he owns on Huangshan.

I’ve barely talked business with him. When I tried this past week to discuss which PE firms have offered him money, he showed scant interest. If I have questions about the company, I talk to the CFO. Early on, the boss gifted me a pretty Chinese calligraphy scroll. I reciprocated with an old piece of British Wedgwood, decorated in an ersatz Chinese style.

Deal-sourcing is both the most crucial, as well as the most haphazard aspect of investment banking work. Each of CFC’s clients has come via a different route, a different process – some are introduced, others we go out and find or come to us by word-of-mouth.  Unlike other investment banking guys, I don’t play golf. I don’t belong to any clubs. I don’t advertise.

Chinese antiques, particularly Song ceramics,  are among the few strong interests I have outside of my work.  The same goes for the GPS company boss. His 800-year old dish and my appreciation of it forged a common language and purpose between us, pairing us like the two carved fish. The likely result: his high-tech manufacturing company will now get the capital to double in size and likely IPO within four years, while my company will earn a fee and build its expertise in China’s fast-growing automobile industry.  

Anyone seeking to succeed in investment banking in China should live by one rule alone: it’s not who you know, but how well you know them. In China, more than any other country where I’ve worked, the professional is also the personal. Comradeship, if not friendship, is always a necessary precondition to doing business together. If you haven’t shared a meal – and more importantly, shared a few hundred laughs – you will never share a business deal. Competence, experience, education and reputation all matter, of course. But, they all play supporting roles.

The stereotypical hard-charging pompous Wall Street investment banker wouldn’t stand much of a chance here. A “Master of the Universe” would need to master a set of different, unfamiliar skills. Personal warmth, ready humor and a relaxed and somewhat deferential attitude will go a lot farther than spreadsheet modeling, an Ivy League MBA and financial dodges to increase earnings-per-share.

I’ve been around a fair bit in my +25 year business career, doing business is over 40 countries and managing companies in the US, Europe and Asia. Everywhere, it helps to be likeable, attentive, courteous. We all prefer working with people we like.  But, since moving to China and opening a business, I’ve learned things work differently here. Making money and making friends are interchangeable in China. You can’t do the first without doing the second.

Investment banking is so personal in China because most private Chinese companies, from the biggest on down, are effectively one-man-shows, with a boss whose authority and wisdom are seldom challenged. Usually, there is  no “management team” in the sense this term is applied in the US and Europe. A Chinese boss is the master of all he (or often she, as women entrepreneurs are common here) surveys.

A substantial percentage of my time is spent getting to know, and winning the friendship, of Chinese bosses. This alone makes me a lucky guy. Without fail, the bosses I meet are smart, gifted, able, hospitable, warm. We don’t select for these qualities. They are prerequisites for success as a private business in China.

Bosses are also usually guarded about meeting new people. It comes with the territory. Anyone with a successful business in China is going to be in very large demand from a very large “catchment pool”, including just about everyone in the extended circle of the boss’s friends, relatives, employees, suppliers, political contacts. Everyone is selling or seeking something. Precious few will succeed. Being a boss in China requires enormous stamina, to deal with all those making a claim on your time, and a gift for saying “No” in ways that don’t offend.

For investment bankers, successful deal generation in China will usually follow an elliptical path. The biggest mistake is to start pitching your company, or a transaction, the moment you meet a prospective client. You need first to win the boss’s trust and friendship, then you can discuss how to work together. In my working life in China, it’s axiomatic that in a first meeting with a company boss, one or the other of us will say, “我们先做朋友”,  or “let’s become friends be first”. It’s not some throwaway line. It’s an operating manual.

The Chinese use a specific word to define the engagement between an investment banker and client. It speaks volumes about the way new business is won here. It’s “合作” or cooperation. You don’t work for a Chinese company, you cooperate with it. There’s got to be a real personal bond in place, a tangible sense of shared purpose and shared destiny.

I could probably teach a class in the cross-cultural differences of investment banking in China and the US. I’ve not only been active in both places, I’ve been on both sides of the table. Before starting CFC, I was CEO of an American company that retained one of the most renowned investment banks in the US to handle an M&A deal for us. At that company, we had a deep senior management team, including two supremely capable founders. We dealt individually and collectively with the investment bank, which had a similarly-sized team assigned to the project.

The relationships were professional, cordial. But, the investment bankers never made any real effort to become my friend, nor did I want them to. Rarely, if ever, did discussions veer away from how to create the conditions to get the best price. The bankers were explicitly pursuing their fee, and we were pursuing our strategic goal.

The deal went pretty smoothly, following a tightly-scripted and typical M&A process. The investment bank’s materials and research were first-rate, and they had no difficulty getting directly to decision-makers at some of the largest software companies in the world. They performed with the intricate precision and harmony of the Julliard Quartet.

I can count the number of times I sat down with the bankers for a nice meal where business was not discussed. Or the number of times when the meeting room rang with peals of friendly laughter. Zero. Both would be unthinkable in China.

Here, a deal is more than just a deal. Price is not the only, or even the main objective. Instead, as an investment banker, you must knit souls together, their lives, fortunes, careers, goals and temperaments. There is no spreadsheet, no due diligence list, no B-school case study, no insider jargon to consult.

Be likeable and be righteous. But. above all, do not be transparently or subliminally motivated mainly by personal greed. A successful Chinese boss will smell that coming from miles away, and recoil. You’ll rarely get past “ 您好” , the polite form of “hello”.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Most investors, over time, will underperform the stock market as a whole. This is as true for people investing their own money in shares, as it is for mutual fund managers, hedge funds, PE and VC firms. So, any investor with a big sustainable “unfair” advantage should seize it.

Right now, in private equity industry in China, certain private equity firms have this unfair advantage. They get the most cash, the most good deals and the most certain exit through a domestic IPO in China. These PE firms are one part of a tripartite alliance, the likes of which the investment world has never seen.  The other two are China’s National Social Security Fund, soon to be the largest source of investible capital in the world, and the CSRC, China’s securities regulator, which has all the say in approving all domestic IPOs.

The PE firms get funding through one, and profits through the other. The deck is heavily stacked in their favor. For the hundreds of other PE firms active in China, including the global giants  TPG, KKR, Carlyle, Blackstone and Goldman Sachs,  making money investing in China is riskier, harder and slower.

Among the PE firms that are members of this new elite in China are CDH, SAIF, New Horizon,  Hony Capital. To many investment professionals outside China, these names will be unfamiliar. Yet, they operate in an environment, and achieve outcomes,  that ought to be the envy of  other investors.

The firms mainly got their start about ten years ago. They were present at the creation of the Chinese PE industry. They raised their initial capital, in most cases, from prestigious American investors, like Stanford and Princeton endowments. The firms’ investment focus has shifted somewhat over time – from technology deals to more traditional industries, from investing only dollars to now using also Renminbi. They did well almost from the beginning. This early success set in motion policies and preferences that have led more recently to their position today.

The two key developments took place within the last 18 months. First, in October 2009, China’s Shenzhen Stock Exchange launched the ChiNext （创业板）board for private companies to go public. It’s been a resounding success, with over 230 companies now listed, having raised over $5 billion from the public. Chinext’s total aggregate market cap is now over $100 billion.

The Chinext p/e multiples, from the start, have been well above levels in the US and Hong Kong. Currently, the average is 42X trailing year’s earnings. The high valuations make it a very profitable place for PE firms to exit from their investments. But, the CSRC acts as a strict gatekeeper, controlling both the number and quality of Chinese companies allowed to IPO on Chinext. Most Chinese firms who apply for Chinext listing are turned down.

The CSRC has a clear preference for companies that have received PE finance from one of the top PE firms in China, since this means, in effect, the company has already passed through a more rigorous due diligence process than the CSRC can attempt. The CSRC’s logic is impeccable: if a good PE firm was willing to put its own capital at risk when the company was private, that business should be a safer investment for public shareholders than a Chinese company without a top PE investor.

Who comes top of the CSRC’s list of favored PE firms? The firms listed above. This means that the companies invested in by these PE firms have a better chance of being chosen by the CSRC to go public on Chinext. In turn,  because of Chinext’s high valuations,  this all but guarantees these PE firms achieve better annual investment returns than others.

When the NSSF announced it was going to begin investing up to 10% of the national pension system’s capital in alternative investments, particularly PE, only a few firms were able to pass through its rigorous selection criteria. It chose firms with strong performance and high standards. Leading the list when the NSSF started handing out money last year: CDH, SAIF, New Horizon, Hony Capital.

The favored PE firms now have access to enormous capital from the state pension fund, along with what seems to be preferential access for its deals to China’s IPO market. In the future, any gains these favored PE firms have from investments using NSSF funds will flow back into higher pensions for millions of Chinese retirees. Will the CSRC consider this, when it deliberates which Chinese companies should be approved for IPO? It seems a fair assumption.

China’s pay-as-you-go pension system only got started recently. So, most of the profits from the PE deals won’t get distributed to pensioners for many years. In the meantime, the gains will be recycled back into more PE investing in domestic companies that then get preferential access to China’s capital markets. It’s a process as elegant as it is practical: Chinese investors bid up the shares at IPO, locking in high profits for a PE firms investing NSSF money. The major part of the PE’s profits is then returned to the NSSF to finance higher pension payments in the future to those same Chinese investors.

All the other PE firms outside this loop, including the global giants, will claim the system is rigged against them, that it’s harder and harder for them to compete with the favored PE firms, and to get approval for their portfolio companies to IPO in China. They probably have a point. But, in the end, this system in China will result in more private Chinese companies getting growth capital, leading to more jobs, more successful IPOs, and more comfortable retirements for China’s many millions. Those are outcomes most Chinese, as well as many others, including me, can endorse unreservedly.

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

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

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

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

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Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

1. China’s current stage of six-pronged development (Slide 2)  
2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9) 

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

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The private equity industry in China continues on its remarkable trajectory: faster, bigger, stronger, richer. CFC’s latest research report has just been published, titled “Private Equity in China 2011-2012: Positive Trends & Growing Challenges”. You can download a copy by clicking here.

The report looks at some of the larger forces shaping the industry, including the swift rise of Renminbi PE funds, the surging importance of M&A, and the emergence of a privileged group of PE firms with inordinate access to capital and IPO markets. The report includes some material already published here.

It’s the first English-language research report CFC has done in two years. For Chinese readers, some similar information has run in the two columns I write, for China’s leading business newspaper, the 21st Century Herald (click here “21世纪经济报道”) as well as Forbes China (click here“福布斯中文”) 

Despite all the success and the new money that is pouring in as a consequence, Chinese private equity retains its attractive fundamentals: great entrepreneurs, with large and well-established companies, short of expansion capital and a knowledgeable partner to help steer towards an IPO. Investing in Chinese private companies remains the best large-scale risk-adjusted investment opportunity in the world, bar none.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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