At ground level here in China, it’s easy to see some of the more obvious signs of the financial distortion this chart portrays. In August last year, in the face of gathering worldwide economic slowdown, the Chinese government relaxed earlier controls on bank lending, basically instructing the state-owned banks to keep the economy and employment growing by expanding credit to businesses. Later in the year, the government lowered interest rates to further spur lending. 

My worry at the time was that most of this increase in bank lending would be channeled to the least deserving customers: the many clapped-out large state-owned enterprises, rather than the far more numerous thriving private sector companies short of cash. This would more or less defeat the purpose of the government pump-priming, since the lending would only allow some of the country’s least competitive most loss-making manufacturers to stay in business that much longer, at the expense of their better private-sector competitors. As a job-saving mechanism, it would likely be equally flawed, since most of the new lending would sustain for a little while longer bad jobs in bad businesses that should be allowed to wither. Failure is rewarded and success penalized. 

Well, the worries appear to have been very well-founded. The most deserving borrowers, China’s dynamic entrepreneurial Small & Medium Enterprises (SME), mainly came away empty-handed when all this new lending was being handed out. As the chart shows, overall bank lending to SMEs didn’t even crack 10% of total lending at four of the largest state-owned banks. With the exception of the more entrepreneur-friendly China Merchants Bank, which also happens to be the only bank on the list not owned by the central government, the large Chinese banks continued their past (bad) habits of stuffing bank loans into the tottering state-owned giants. 

The eventual outcome, of course, will be a lot more write-offs and non-performing loans inside these state-owned banks. For an abject lesson in bank lending policy, it’s hard to outdo this: the government-owned banks make loans to other government-owned bodies, which then default, causing losses at the government-owned banks that then need to be recapitalized by – you guessed it – more money from the government. 

There’s an even more malign effect: it’s actually getting harder – not easier – for China’s best-performing SMEs to obtain credit. These are the companies that are producing products consumers want, expanding employment, servicing their loans, making profits and paying taxes. The private sector now accounts for over two-thirds of China’s total economic output, and private SMEs represent the bulk of this. 

The Macquarie chart suggests the credit system of China state-owned banks is largely broken: borrowers least able to repay are those granted most of the lending. There are lots of losers in this, but no one is affected more adversely by this than the owners of China’s best SMEs. They are being locked out of the market for bank lending by Chinese banks. 

That leaves one possibility: SMEs finance their expansion through equity, rather than debt. This investment capital will come from outside the realm of China’s state-owned banks. Instead, it will largely be provided by the 100 or so private equity and venture capital firms now active in China. They have raised over $30 billion to invest in China, and the SMEs are a favorite target. 

Of course, not all SMEs will be able to raise equity. It’s generally an option only for the higher-performing SMEs with significant scale and significant presence in China’s domestic market. My company is an international investment bank working exclusively with Chinese SMEs, to help them raise equity finance from the best sources active in China, mainly the top private equity and venture capital firms.  The challenge for us, as for the private equity firms, is that too few of China’s best SME bosses know that they can access private equity investment and so escape from the perils of undercapitalization. 

For the SMEs that can raise money from international investors, this is not just the best option – but also often the only option – to finance growth. An injection of equity will deliver both the resources to grow more quickly and sizable competitive advantage against under-capitalized competitors. 

An additional advantage: by raising equity, an SME will strengthen its balance sheet and so be more likely to succeed in borrowing from one of the very good international banks with operations in China and a focused expertise on lending to Chinese SMEs: Citibank, Standard Chartered, ABN-AMRO foremost among these. I know the management in Shenzhen of all three banks. They are very well-run and very well-connected among SMEs across China. The three international banks bridge the huge gap created by Chinese state-owned banks failures to make adequate lending available to SME customers. 

For Citibank and ABN-AMRO, their current performance in China, founded on their strong presence in SME lending, is one of the only bright spots for two organizations that could do few things right elsewhere recently. Together, they lost over $30 billion last year, and Citibank is now a ward of the US government. 

Everything ABN-AMRO and Citibank did so spectacularly wrong in other countries, they do spectacularly right in China – they focus on the right clients, the right kind of products (loans to growth companies) and having steady bankers, not deal-makers, at the top.  If Citibank and ABN-AMRO are ever to recover their lost luster globally, they should learn from the example of their China operations. The banks represent two of the brightest hopes for the future financing of China’s SME entrepreneur class. 

In China today, there is no larger financial need – and no larger financial opportunity for investors – than to put additional finance into strong fast-growing private SMEs. This will allow them to grow most immediately into the leaders in China’s domestic market, and eventually, for some, into publicly-traded global businesses. 

China’s state-owned banks, meanwhile, will likely continue on their wayward path of lending to companies with more political clout than business ability. It’s a losing strategy for them. But, it’s one that creates ideal conditions for well-managed international banks in China, with the skills, market knowledge and focus to lend to SMEs (take another bow Citibank, Standard Chartered, and ABN-AMRO), to prosper alongside their SME clients.  

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As the Chinese National Congress meets this week in Beijing to plot the course of the Chinese economy in 2009 and beyond, it’s worth reflecting what an exceptional, juddering year 2008 was. Sure, the Olympics stole most of the headlines, and provided the lasting images of Chinese progress and triumph. But, those images also dulled, in many respects, our perceptions of the brunt force of the economic blows China sustained during 2008. Make no mistake, 2008 was a year of challenge, disruption and dislocation not seen in China for a generation or more. 

The year started with the worst winder storms in decades. This was followed, just months later, by the cataclysmic Wenchuan Earthquake in Sichuan. Beyond the colossal loss of life and destruction, the earthquake had a much broader, unprecedented social impact across China. There was an enormous outpouring of national compassion and grief. While wholly positive as an expression of China’s rightful growing self-confidence, this vast prolonged period of national mourning also had a very direct and negative impact on economic activity. For weeks if not months, as I saw firsthand, there was a tangible unwillingness to spend as freely, to enjoy life as unabashedly as in the years previously. It was as if much of China received some intimation of their own mortality in the wake of the Sichuan Earthquake. 

Next came an accelerated fall in property values across much of China. Alongside this, the stock market fell sharply. These two, the property and stock markets, are the main stores of wealth for many middle class Chinese. People felt poorer because they were poorer. The fall of both property and share prices wiped away billions of dollars in national household wealth. People in their hundreds of millions were suddenly poorer, as household net worth plummeted, and Chinese pulled back even more strongly from their spending. Then, in late summer, came the financial tsunami in the USA, with the credit crisis, the collapse of Lehman Brothers, and the intensifying recession. 

Any basic college economics textbook – to say nothing of common sense — could foretell the next step: a fall in overall confidence levels among Chinese consumers. This further muffled already depressed levels of personal spending. 

We’re now well into the first quarter of 2009, and my own sense, after spending these last three weeks in China, is that the cumulative impact of all of 2008’s bad news is still being felt, acutely. However, my sense is that the worst may indeed be over, and that 2009 will be a year of rebuilding and reasserted economic confidence in China. 

Of course, when talking about general economic trends in the world’s third largest economy, a lot of the clarifying detail gets lost. But, we have a real sense, in our day-to-day work, of just what an extraordinarily difficult year 2008 was for even the best Chinese businesses. Our firm, China First Capital,  has focused on serving China’s middle market private Small and Medium Enterprises (SMEs), assisting them with capital-raising strategic M&A and other financial transactions.

Unlike traditional investment banks reliant mainly on short-term transactions, China First Capital’s role as financial and strategic advisor to Chinese SMEs often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Even our strongest clients had a tough time in 2008. In one example, a business that is one of China’s leading consumer fashion brand, maintained outstanding growth last year in overall revenue, with domestic sales rising by 30%.  That’s mainly testament to the company’s no less outstanding management and brand-positioning. But, the bottom line was less stellar. Profit margins were squeezed, and the company earned half as much in 2008 as it expected to as late as July 2008. That represents a shortfall against plan of almost $6mn. That equates, of course, to having less money to invest in building on that growth rate in 2009.  

They remain a great company, and there’s little doubt 2009 will be a better year. But, when we met with them recently, the company’s financial management are still reeling from the brutal effects of 2008. If nothing else, it drives home as little else can the importance of fortifying the company’s balance sheet, which has been overly-reliant on retained earnings and short-term bank loans to finance growth. This client, like the Chinese economy, has weathered the once-in-a-generation turmoil of 2008. Better days lie ahead — my bet is sooner, rather than later.  

My firm, China First Capital, just completed our annual report on Private Equity, Venture Capital and Strategic Mergers and Acquisitions in China. I had the biggest hand in writing it, so the opinions expressed are my own. My view, overall, is one of realistic optimism. China will continue to be the world’s most robust emerging market for private equity and venture capital finance, even in a very difficult global economic environment. A big reason for this is the continuing strong performance of many private SME companies in China, especially those focused on the domestic market, rather than exports. 

China First Capital has a special affinity for these strong private SMEs. They are the only companies we choose to work with. There a few reasons for this. A big one is my personal conviction that the most important predictor of a success in private equity investing is putting money into a company with a truly outstanding boss. Ideally, the boss will also be the entrepreneur who founded the company. 

You can do all the spreadsheet modeling and projections you want, but nothing else matters quite as much as the quality and drive of the leadership at the top. In many of the good Chinese SMEs, the boss is a first-class business strategist and opportunity-seeker. Give him a dollar and he’ll bring you back five. In many of China’s larger state-owned, or partially state-owned companies in China, the boss is often more a political animal, appointed to the job as much for skills as a bureaucratic infighter as for talents at managing a business. Give him a dollar and he’ll come back in a while and ask you to lend him another three. 

SMEs, no surprise, usually run circles around their state-owned competitors in China. That’s a big reason we choose to work exclusively for SMEs. Another reason: we prefer long-term partnerships with our clients rather than one-off deal-making of larger investment banks. We act as a financial and strategic advisor to Chinese SMEs in a long-term process that often begins at early stages of corporate development and continues through the capital raising process from private equity to a successful IPO and beyond to global leadership. 

Thanks to these Chinese SMEs,  China should be among the most attractive – and active – private equity investment markets in the world in 2009. Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Indeed, private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1 billion in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market.

Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.

The report, titled “Private Equity and Strategic M&A Transactions in China 2009”, identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are:

1. the drive for industrial consolidation;
2. profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA;
3. increased importance of Convertible Debt and other hybrid financings;
4. opportunities for strategic mergers and acquisitions;
5. well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market.

Here’s the report’s first section. I’ll add more of it in later posts.

 Overview  

Turbulence creates opportunity

2008 was a year of extremes in China. Extremes of joy and pride, during the Beijing Olympics. Extremes of sadness and shock following the Sichuan earthquake. Even the climate reached extremes, during China’s crippling winter storms early in 2008. 

Financially, 2008 was also a year of extremes. The stock markets in Hong Kong, Shanghai and Shenzhen rose strongly in the first months of the year, and IPOs were plentiful. By mid-year, the markets began plunging, and IPOs dried up. By year-end, Shenzhen, Shanghai and Hong Kong were all down 60% for the year. 

China’s private equity and venture capital investments followed a similar turbulent course, beginning strongly, with over $10 billion invested in Chinese companies in the first half of the years, and then the pace of new investments slowed to a crawl.   

Governments in China, the USA and around the world intervened in an unprecedented fashion to stabilize the economy and the credit markets. As we enter 2009, there is no longer any doubt that the world economy is in recession. 

The question now is when will the recovery begin and when will be a good time to begin investing again? I want to offer a personal perspective to our valued relationships, both clients and the private equity firms we work with. As Chairman of China First Capital,  Ltd, with over 20 years of experience in the capital markets, private equity and business analytics, I’ve survived my share of business cycles. One example, I was CEO of a California venture capital company during the Dot-Bust years, the last time private equity investing came to a similar standstill. Within two years, deal activity and valuations resumed their upward momentum. 

My view: the overall investment environment in China remains challenging and the effects of 2008’s turbulence are still being felt. But, 2009 will be a year of unique opportunity for private equity, venture capital and mergers and acquisitions in China. Tough times can be the best time to make money. 

The Chinese economy is under significant strain as 2009 begins, with growth decelerating, factories closing by the thousands and unemployment rising. Many areas of China’s domestic economy are “over-saturated”, with too many companies competing with small market shares. China is ripe for consolidation. 

In the freely competitive markets, the weakest companies will perish. The stronger competitors will be able to add market share and enjoy the virtuous cycle of increasing volumes lowering unit costs, thus boosting profits that can be re-invested to lower still further costs of production.

Chinese consumers will respond as well, and reward with more of their money the better managed companies with the most efficient manufacturing and distribution. Out of this, stronger dominant brands will emerge, and this too will push for greater consolidation.

This process is just beginning in China. China’s domestic market is huge, second only to the US. In many vertical markets (including financial services, consumer goods, distribution and logistics, retailing, fashion), each point of additional market share in China can equate to tens of millions of dollars in additional revenue.

Chinese companies are still, most often, small-in-scale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate Strong regional companies will acquire competitors elsewhere in China to become national powerhouses.   

For investors, the opportunities will be unparalleled to back the Chinese companies that will thrive during this process of consolidation.  The winners will be able to increase revenues and profits strongly and sustainably, even in a weak economy.