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

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

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

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

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

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

-

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

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

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

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

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

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

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

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

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

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

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

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

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

The first thing that strikes you is complete geographic implausibility of it all. In a rural corner of China’s barren, sparsely-populated and dusty Loess Plateau, sits an enormous complex of factories, dormitories, roads, and train tracks occupying an area of 38 square kilometers (14.6 square miles, almost 19 million square feet). That’s over half the size of Manhattan, 58 times larger than LA’s Disneyland, three times larger than the world’s busiest international airport, Heathrow in London.

The site belongs to a single Chinese company. It’s private, been in business less than a decade, has come from nowhere to become the world’s largest manufacturer of a critical component used in steel production, with likely revenues this year of over USD$1.5 billion (Rmb10 billion), profits of over USD$130 million , and assets of over USD$2.4 billion (Rmb 15 billion).  It’s 99% owned by its founder and chairman, with the other 1% held by his wife and daughter. By any measures, it is among the largest private industrial companies in the world, and certainly among the fastest ever to get to $1 billion in sales.

Not only have you never heard of it, neither has virtually everyone in China. It’s never listed among the biggest private companies in China. Its owner is never included among the ranks of the country’s private sector billionaires. Just how unknown is this remarkably successful entrepreneur? Here’s one measure. Believe me, I’m a big nobody in China. But, a Baidu search turns up more articles and references to me and my company than to this company boss and his.  In terms of orders of magnitude, his company employs about 2,000 times more people than mine, and occupies a premises that’s about, well, 190,000 times larger.

I’m not going to disclose the company or the boss’s name. We’re in discussions with them, and it would be unprofessional to do so. None of my competitors, as well as virtually no credible PE firms,  have visited the company.

My purpose here is two-fold: to shed a little light on a remarkable individual entrepreneurial achievement and also to give some sense of the scale of entrepreneurial greatness in China. I find myself, more often than I’d like, drawn into discussions – occasionally arguments – with people in the US and Europe about how entrepreneurship in China is in a class by itself, compared to everywhere else in the world, excepting perhaps the US and Israel.

Entrepreneurs are more numerous here (over 70 million private companies) and the best ones, numbering at least in the thousands, have created more wealth and spawned more positive societal progress in the last ten years than any other single group of people on the planet. I live in a perpetual state of wonder, doing what I do for a living in China, having occasion to meet entrepreneurs of the caliber of this particular boss.

A little more about him. He is, by my eye, about as modest an individual as you would likely ever run across. The only obvious concession to his enormous wealth is a rose gold watch he wears along with standard-issue baggy Chinese suit. If he sat next to you on a plane, my guess is you’d pin him as the owner of a small hardware store, not the owner of the world’s largest manufacturing business for a component used in a lot of what’s for sale there.

His office is hardly palatial, and sits just above the oldest section of his giant factory complex. He never went to college, and has no engineering or technical background, despite founding and now running one of the more complicated large-scale engineering and manufacturing businesses you’d ever hope to see.

Everything about the man, except his ego, is huge. “If you are going to do something,” he tells me, “do it big.” This applies not only to the huge area his business occupies, but the size of the investments he is making in its future. He is taking his business downstream and building, simultaneously, at least four huge new production sites, with total planned investment of over $3 billion. The local government is busy decapitating the top half of a silt mountain to create a level 500 acre site (about one square mile) for one of these new production areas. He begins building on it this year.

As I drove away from the factory area, I remarked to my colleague that the whole complex must be a source of intense interest at the CIA and National Security Agency in Washington, DC. Satellite photos will show the vast scale of this enterprise, as well as all the construction taking place. One recently-completed building is four stories tall and a mile long, all indoors.

My guess is the two spy agencies aren’t all that sure what exactly is being produced or planned here. I drove through it. Within a year, it will start producing steel products for the auto and home appliance industry.

How did this one entrepreneur build such a huge business is such a short time? Obviously, good timing, luck, some support from his local government and banks played a part. But, one key factor was a gamble he made in 2008 that paid off big time. When the financial crisis hit, his state-owned competitors (there were once three within a few hundred miles of him) cut way back on raw material purchases. This boss did the opposite. He exploited a steep drop in commodity prices, bought big and so locked in very large profits when customer demand began to pick up in 2009. Of course, had prices kept falling, he would have likely been bankrupt. His state-owned competitors? Now, all out of business.

Just about every “yuan” of profit he earns is poured back into expanding production. His bank loans are moderate –  about 10% of total assets. He’s only drawn down 70% of the credit lines provided by local banks. Measured by scale (factory size, employees, revenues) his company is similar to many larger SOEs in China. Asked to make a comparison, he explains that SOEs target only top line growth — girth for its own sake. He is far more focused on making money. The projected annual rate of return on newer projects is well above 25%.

He’s thinking about an IPO within two to three years. At a guess, his business could have a market capitalization at that point in excess of USD$8 billion. An IPO on that scale will bring him a lot of unwanted notoriety. He would likely instantly be vaulted into the ranks of the five hundred richest people on the planet. Billionaires in China rarely have it easy. Quite a few seem to end up in prison, or targeted by waves of bad publicity. For him, the real appeal of going public is the potential to raise an additional $1.5 billion to $3 billion to invest in further downstream expansion.

Whether or not my company works with his, it was one of the signal delights of my 35-year professional career to meet this entrepreneur, tour his factories and eat in his dining room.  At this moment in history, China is the entrepreneurial center of the world.

-

My love story began 25 years ago on a bus barreling down the Mass Pike highway in Western Massachusetts. It continues to this day, stronger and more captivating than ever. It has provided the joy, the passion, the inspiration, the endless study and purpose of my life. I’m talking about my love affair with entrepreneurs and entrepreneurship. 

Twenty-five years ago I was a newly-hatched baby reporter at Forbes Magazine in New York, on my first proper reporting assignment. An editor asked me to look into what was then still a small New England bus company with the unlikely name of Peter Pan Bus Lines. Against the odds, little Peter Pan was competing, and somehow winning, against America’s giant intercity bus company, Greyhound. I took one of their busses from New York’s dreary Port Authority station to the company headquarters in Springfield, Massachusetts. 

I sat down with the company’s CEO, Peter Picknelly. He gave me my first lesson in what it’s like to be an entrepreneur, the challenge and the delight of taking on – and eventually taking down – a big rival. To my surprise, as well as my editors, I was able to turn the conversation into an article that made it into Forbes, under my byline. My first. I was hooked– not so much with reporting and journalism. That was purely a means to an end. My life’s direction became meeting and learning from entrepreneurs.

At that time, I knew and cared little about small business and entrepreneurs. Both my grandfathers were founders of successful companies. But, growing up under their noses, I never quite appreciated just how special they — and their fellow entrepreneurs – really were. Only when I landed at Forbes, after years of studying Chinese history, then spending time in China and Hong Kong as a grad student, did it first begin to dawn on me how much I had to learn, and how deeply I should admire, the people who take the limitless risk to start businesses, find and please customers and, not all that infrequently, end up changing the world for the better. 

Fast forward to today, and I’m living a life that is the culmination of this 25 years of meeting, talking with, learning from some of the best entrepreneurs in the US, Europe and now China. In the four years since starting CFC, I’ve met in China more great entrepreneurs than in the previous 21. That is no small accomplishment, since among the entrepreneurs I met previously are Bill Gates, Miuccia Prada, Ken Olson and dozens more, less famous, but in many senses, no less remarkable and successful.

Entrepreneurs in China share much the same profit-making and opportunity-seeking DNA of entrepreneurs elsewhere. What makes them more remarkable, though, is fact that almost all got their start at a time when entrepreneurship, when starting your own company, was new, untried, often hazardous in China. They not only had to overcome the obstacles familiar to entrepreneurs everywhere (where do I find the money? How do I make a profit, feed my family and reinvest? What about my larger competitors?) but a raft of others that would daunt just about any other sane individual. 

Until comparatively recently, China’s economy was a near-perfect socialist vacuum in which entrepreneurship could not survive.  The economy was almost entirely in state hands. Licenses were not granted to private businesspeople. Banks would not lend. This was the world today’s successful Chinese entrepreneur was born into. There were no role models. The previous generation of private entrepreneurs had, in large part, been expropriated and excoriated or fled the country in 1949. 

Laws giving equal treatment to private companies were only introduced in 2005. Even then, private companies have had it very tough, in many cases. It remains a challenge. Taxes are numerous and high. Regulations can be as stifling as anywhere else in the world. Laws change frequently. Worker salaries are now growing by 25% a year or more. Every good business idea, almost within minutes, attracts hundreds, if not thousands, of competitors. Success or failure can be conferred at the whim of a local bureaucrat. 

And still, the great entrepreneurs of China keep marching forward, in ever greater numbers. A week doesn’t go by when I don’t meet or hear about a successful and accomplished entrepreneur. I’m just back from a five day trip to cold and barren Northwestern China. For me, it was far more enjoyable than a long weekend on the beach at Bali. 

During my trip, I met back-to-back with the founders of nine different companies, sharing hours of discussion with each, and a delicious meal with most. Each of the nine is successful, in industries ranging from cooking oil to laser components, from high-tech fiberglass threads to the world’s largest producer of a refined mineral used by steel mills all over the world. 

In my next blog post, I will tell the story of this mineral company and its remarkable founder. In eight years, since starting his business with little capital and no relevant experience or higher education, he has built a business worth, conservatively, $2 billion. He owns 99% of it. His wife and daughter the remaining 1%. 

Each of these entrepreneurs, like so many others in China and elsewhere, will achieve more in their lives than most, and likely leave a lasting imprint on generations to come. This was true for my grandfathers, whose success (one as the owner of a department store, the other as the founder of a button-making company) in the middle part of the 20^th century created the wealth to send their children to college, get advanced degrees, and so ultimately provide a very affluent upbringing and even more possibilities in life for me and my brothers and cousins. 

The roots of so much of my own happiness are opportunities and experiences made possible by the business success of my two entrepreneurial grandfathers. It is the greatest of privileges for me to now work helping in a small way some outstanding entrepreneurs here in China.

-

-

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

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

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

The report is available in Chinese only.

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

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

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

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

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

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

-

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

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

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

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

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

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

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

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

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

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

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

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

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

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

“Women”, in Mao Zedong’s memorable phrase, “hold up half the sky”. While not strictly the case in the business world, Chinese women do play a far more prominent role, both in starting and running big companies in China, than their sisters do elsewhere, particularly in the US and Europe.

According to a study last year by accounting firm Grant Thornton,  women hold 34% of the senior management positions in China, compared to an average of 20% elsewhere in the world. The percentages are also moving in opposite directions, with a greater proportion of top jobs in China going to women recently. Women held 31% of management jobs in China in 2009. Meantime, women are becoming less common in senior management in Europe and US, down from 24% over the same period.

And, no, it’s not just a case of women dominating “soft functions” like HR and accounting, as they often tend to do in the West. In China, 19% of women in management roles are serving as CEOs, compared to 8% elsewhere. A significant quotient of partners at private equity firms in China are women. The most talented and capable person in investment banking in China I know, Wang Yansong,  is female — even better, she works with me.

If there is a “glass ceiling” in China, it must be quite porous.

In my three-plus years in China, I’ve met far more successful big-time women entrepreneurs and bosses than I did in 25 years working in US and Europe. I’ve also been lucky enough to work with several, including one of China’s most well-known entrepreneurs, Mrs. He Yongzhi, the founder of the country’s largest spicy hotpot restaurant chain, 小天鹅, or “Little Cygnet”, with over 400 high-end restaurants across China.

Mrs. He started the business 30 years ago in a tiny alcove, with just five tables –no capital, no powerful backers and a competitor on every street corner. And yet, she has thrived. She invented the now-ubiquitous “yin-yang” twin-flavored stock pot commonly used not just in her own restaurant but in hotpot restaurants around the country.

Along with the restaurant chain, she also runs a food processing company, producing bottled hot sauces with her face on every label, and a large commercial real estate business, including five hotels in Chongqing, Sichuan and Tibet. Her daughter Weijia is a chip off the entrepreneurial block,  having started a high-end tea business called Nenlü.

Mrs. He’s  restaurant company has Sequoia Capital as an investor, and is planning an IPO next year that will likely make her into another of China’s self-made billionairesses. Already, half of the world’s self-made billionaires are from China. Over 10% of the richest businesspeople in China are women. That may not sound like much, but is light-years ahead of most every place in the world. In a typical working year, I will meet at least 10 women bosses who are well on the way to building an enormous fortune as founder and majority-owner of companies that may likely one day have an IPO in China.

Indeed, it’s one of the great joys of my working life, that I meet so many great “lady laoban”, as we call them, using the Chinese word for “boss”. I especially like meeting with women running metal-bashing businesses.  One of the more successful and elegant women bosses I know started and runs one of China’s largest private auto parts companies, making aluminum ventilation and heating systems for cars and large trucks.

At the factory, she wears a smock with the cotton elbow-protectors once in vogue among 19^th century English bookkeepers. Her husband works for her, as head of the security team. Her likely successor? Her one daughter, a recent new mom, who runs the company in tandem with her mother. Both mother and daughter are warm, lovely, attractive, fully at ease talking to truck mechanics and engineers, or walking the factory floor.

It may be a coincidence, but many of the women bosses I know do not have sons. Only daughters. Did they work harder in their professional lives to overcome the stigma (then large, now thankfully smaller) of having only girl children? It could be. But, such Western-style psychological theorizing seems misplaced. China has more great women entrepreneurs because 30 years ago, as China was ending its costly experiment with Maoist socialism, there were new huge areas of money-making opportunity open to all.  Gender mattered less than ambition, diligence, persuasiveness, business acumen and leadership skills. China after 1978 was a commercial “tabula rasa”. There were few established business rules and basically no role models (positive or negative) for anyone to follow.

China traditionally is a male-focused society, with deep-set roots in Confucian thinking that put husbands and sons well above the rank of wives and daughters. In many ways, this mindset still persists in China. And yet, paradoxically,  a society that puts men on a higher social plane can also provide women entrepreneurs with something of a level playing field in business.

In the last year, along with the two lady bosses already mentioned, I’ve met women who started and now run successful companies that make high-end LED screens, lease cars, provide an online B2B transaction platform, make and export embroidered blankets to Williams Sonoma. Never once have I heard a complaint about gender-discrimination or even a hint that the company has been victimized by negative perceptions about female bosses.

In the end, starting a company anywhere requires a tolerance of — if not full bear hug embrace of — risk. Women, so I’ve read, are programmed from birth to shun risk. It’s meant to be the reason there are comparatively few women combat soldiers and motorcycle riders, as well as successful entrepreneurs.

Gender theorists obviously never looked closely at China. Equally, Chinese women weren’t taught why they were destined by biology to underperform men in the workplace, to start fewer businesses, to climb high on fewer corporate ladders. Spared knowledge of these “facts”, they’re in full pursuit of their dreams and ambitions.

-

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.  

-

CFC’s latest Chinese-language research report has just been published. The topic: M&A Strategy for Chinese Private Companies. Our conclusion: propelled by rapidly-growing domestic market and the continuing evolution of China’s capital markets, China will overtake the USA within the next decade as the world’s largest and most active market for mergers and acquisitions.

The report, titled “ 并购- 中国企业的成功助力”，can be downloaded by clicking here.

The report identifies five key drivers that fueling M&A activity among private sector companies in China.  They are: (1) a once-in-a-business-lifetime opportunity to seize meaningful market share in the domestic market; (2) the coming generational shift as China’s first generation of entrepreneurs moves toward retirement age; (3) a widening valuation gap between private and publicly-traded companies; (4) regulatory changes that will make it easier to pay for acquisitions using shares as well as cash; (5) increased access to IPO market in China for companies that have augmented organic growth through strategic M&A.

Several case studies from our work feature in the report, including a cross-border M&A deal we are doing, and one purely domestic trade sale. We take on a select number of M&A clients, and work as a sell-side advisor.

M&A in China has myriad challenges that do not often arise in other parts of the world. One we see repeatedly is that few Chinese acquirers have in-house M&A teams or investment banks on call to provide help with structure and valuation. Talking with anyone less than the company chairman is often a waste of time.

Another unique hurdle: “GIGO DD” or, more prosaically, “garbage in, garbage out due diligence.” Potential acquirers unfortunately will often start their industry research by doing a Chinese language web search using Baidu. There is a lot of dubious stuff out there that is given some credence, including phony websites and bizarre claims posted to people’s personal blogs or chatrooms.

In the cross-border deal we’re working on, several companies backed out of the process after finding Chinese companies claiming on their corporate website to make equipment identical to our client’s. This convinced these potential bidders that our client had technology and assets of little value. We actually took the time, unlike the potential acquirers, to call the phone numbers on these websites, posing as potential customers. None of the companies had any similar equipment for sale or in development. The material on their websites was bogus.

Market data from online sources is also usually specious. Few people, including lawyers, have working knowledge of how an M&A deal might impact a company’s plans for domestic IPO in China.

I’ve been inside some M&A deals in the US,  with their online data rooms, cloak-and-dagger codenames, and a precisely orchestrated bidding process. In China, the process is more unscripted.

Until recently, the only Chinese companies able and willing to do M&A were larger State-Owned Enterprises (SOE). The deals were done to buy oil and other natural resources on the stock market, or to acquire European brand names to put on Chinese-made products. Those deals include Sinopec’s purchase of shares in Canadian company Addax， CNOOC’s failed acquisition of UnoCal, TCL’s purchase of Thomson TVs and Alcatel phones, and Nanjing Automotive’s buying the MG brand.

These kind of deals will likely continue. But, in the future, M&A deals will become more numerous, more necessary for private entrepreneur-founded companies and have more complex strategic goals.

M&A is one of only two ways for founders and shareholders to achieve exit. The other is IPO. But, the number of private companies who can IPO in China will always be limited. At the moment, the number is about 250 per year. Compare that to the 70 million or so private companies in China.

The IPO process creates a special competitive dynamic in China. The first company in an industry to become publicly-traded usually has a huge advantage over competitors. They disrupt the previous equilibrium in an industry.

This means there are only two choices for many entrepreneurs. Both choices involve M&A. If you aren’t going to become a public company or a competitor has already gone public, you need to consider selling your company. If you want to become a public company,  you will need to become an expert at buying other companies.

The economic destiny of China, and many of its better private companies, is M&A.

-

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.  

-

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.

-

-

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.

-

-

Leonardo DiCaprio does something in China that he dare not do in the US: peddle product. He is appearing now, unnamed but clearly recognizable, in ads for a Chinese domestic mobile phone brand called Oppo. His face is currently plastered all over my local subway station in Shenzhen.

It’s a bold move by a little-known Chinese mobile phone company to storm into the big time, and grab market share from Nokia, Samsung, LG and Apple. None of these global brands uses a big name to front its ads in China. Oppo is determined to compete as equals with these larger companies. It’s still learning the rules of building a successful brand. Its tactics and ad strategy are a little off-beat. But, Oppo has the resources and distribution in China to challenge the large global mobile phone brands, and so cause them headaches in the world’s largest mobile phone market.

The ads are a bit of a head-scratcher. They are framed to look like a strip of celluloid and feature, in the background, a European cobblestone street, a moped making a fast getaway while someone, maybe Leo, gives chase. The only text are the words “Find Me”, in English. In other words, it doesn’t have anything to do with mobile phones, not even subliminally. It looks like a movie poster. Still, seeing an A-List Hollywood star in a Chinese ad for a Chinese brand is no workaday occurrence.

Leo is hugely popular in China, especially among women under 40.  “Titanic” may well be the most-watched American movie of all time in China. No one knows for sure, since the movie came out in 1997, and circulated in China mainly through pirated video and DVDs.

Getting Leo to appear in the ads is quite a coup for Oppo. The Chinese company reportedly paid Dicaprio $5 million. A steep price, but the company is betting that Leo can pry open wallets in a way no other celebrity endorser can. The reason: Oppo is the only “girls only” major mobile phone brand in the world. The company’s phones are all aimed at, and advertised to, females.

Oppo’s phones are all  pretty standard, with no unique technology under-the-hood. But, they come in bright colors and feature girly do-dads like crystal keys. Oppo’s marketing, with the exception of the new DiCaprio ad, features Chinese women traveling in exotic locations, or chatting with friends.

Oppo is trying to pull off a challenging feat:  to catapult above the hundreds of no-name mobile phone manufacturers and brands, and establish itself as a premium brand in China. The other Chinese mobile phone brands do little to no advertising, and instead compete mainly on price. With its big ad budget and quirky strategy of targeting women from 18-40, Oppo aims to compete head-to-head with Samsung, Nokia and Apple.

Will it work? My guess is that Oppo will get a decent return for the $5 million spent on DiCaprio. The Chinese market is ready for a splashy self-confident Chinese domestic phone brand with some star power.

“Cometh the hour, cometh the man.”

-

-

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.

-

-

Selling a business in the US?  Chinese can pay top dollar.

We are entering a golden age of Chinese M&A deals in the US. There is certainly a sharp pick-up in activity going on – not so much of announced deals yet, though there have been several, but in more intensive discussions between potential Chinese acquirers and US companies. There is also a lot more shopping and tire-kicking by Chinese buyers. I certainly see it in our business. We’re engaged now in several M&A deals whose goal is sale of a US company to a Chinese buyer. I expect to see more.

The reasons for this upsurge are many – including the recent appreciation of the Renminbi against the dollar, the growing scale and managerial sophistication of Chinese companies (particularly private as opposed to state-owned ones), attractive prices for target US companies, the launch in 2009 by the Shenzhen Stock Exchange of the Chinext board for fast-growing private companies.

The best reason for Chinese buyers to acquire US firms is one less-often mentioned – to profit from p/e arbitrage. The gap between stock market valuations in the US and China, on price-earnings basis, are wide. The average trailing p/e in the US now is 14. On China’s Chinext board, it’s 45. For fast-growth Chinese companies, the p/e multiples can exceed 70. This gives some Chinese acquirers leeway to pay a higher price for a US business.

In the best cases, a dollar of earnings may cost $10-$15 to acquire through purchase of a US business, but that dollar is immediately worth fifty dollars or more to the Chinese firm’s own valuation. As long as the gap remains so large, it makes enormous economic sense for Chinese acquirers to be out buying US businesses.

This is equally true for Chinese companies already quoted on the Chinese stock market as well as those with that ambition. Indeed, for reasons unique to China, the incentive is stronger for private companies to do this p/e arbitrage. In China, public companies generally are forbidden from doing secondary offerings, nor can they use their own shares to pay for an acquisition. When a Chinese public company consolidates a US acquisition’s profits, its overall market value will likely rise. But, it has no way to capitalize by selling additional shares and replenish the corporate treasury.

For a private company, the larger the profits at IPO, the higher the IPO proceeds. An extra $1 million in profits the year before an IPO can raise the market cap by $50mn – $70mn when the company goes public on Chinext. Private Chinese companies, unlike those already public in China,  can also use their shares to pay for acquisitions. The better private companies also often have a private equity investor involved. The PE firms can be an important source of cash to finance acquisitions, since it will juice their own returns. PE firms like making money from p/e arbitrage.

In M&A, the best pricing strategy is to swap some of my overvalued paper to buy all of someone else’s undervalued paper.  At the moment, some of the most overvalued paper belongs to Chinese companies on the path to IPO in China.

Most M&A deals end up benefitting the selling shareholders far more than the buyers. That’s because the buyers almost always fail to capture the hoped-for savings and efficiencies from combining two firms. Too often, such synergies turn out to be illusory.

For Chinese acquirers, p/e arbitrage greatly increases the likelihood of an M&A deal paying off – if not immediately, then when the combined company goes public.

If the target company in the US has reasonable rate of profit growth, the picture gets even rosier. The rules are, a private Chinese company will generally need to wait three years after an acquisition to go public in China. As long as the acquired business’s profits keep growing, the Chinese companies market value at IPO will as well. Chinese acquirers should do deals like that all day long.

But, as of now, they are not. One reason, of course, is that things can and often also go wrong in M&A deals. Any acquirer can easily stumble trying to manage a new business, and to maintain its rate of growth after acquisition. It’s tougher still when it’s cross-border and cross-cultural.

Another key reason: domestic M&A activity in China is still rather scant. There isn’t a lot of experience or expertise to tap, particularly for private companies. Knowing you want to buy and knowing how to do so are very different beasts. I’ve seen that in our work. Chinese companies immediately grasp the logic and pay-off from a US acquisition. They are far less sure how to proceed. They commonly will ask us, investment bankers to the seller, how to move ahead, how to work out a proper valuation.

The best deals, as well as the easiest, will be Chinese acquiring US companies with a large untapped market in China. Our clients belong in this camp, US companies that have differentiated technology and products with the potential to expand very rapidly across China.

In one case, our client already has revenues and high profit margins in China, but lacks the local management and know-how to fulfill the demand in China.  The senior management are all based in the US, and the company sends trained US workers over to China, putting them up in hotels for months at a time, rather than using Chinese locals. Simply by localizing the staff and taking over sales operation now outsourced to a Chinese “agent”, the US company could more than double net profits in China.

The US management estimates their potential market in China to be at least ten times larger than their current level of revenues, and annual profits could grow more. But, to achieve that, the current  owners have concluded their business needs Chinese ownership.

If all goes right, the returns on this deal for a Chinese acquirer could set records in M&A. Both p/e arbitrage and high organic profit growth will see to that. Our client could be worth over $2 billion in a domestic IPO in China in four years’ time, assuming moderate profit targets are hit and IPO valuations remain where they are now on China’s Chinext exchange.

Another client is US market leader in a valuable media services niche, with A-List customers, high growth and profits this year above $5mn. After testing the M&A waters in the US, the company is now convinced it will attract a higher price in China. The company currently has no operations now in China, but the market for their product is as large – if not larger – than in the US. Again, it needs a Chinese owner to unlock the market. We think this company will likely prove attractive to quoted Chinese technology companies, and fetch a higher price than it will from US buyers.

The same is true for many other US companies seeking an exit. US businesses will often command a higher price in China, because of the valuation differentials and high-growth potential of China’s domestic market.

China business has prospered over the last 20 years by selling things US consumers want to buy. In the future,  it will prosper also by buying businesses the US wants to sell.

-