Of all the rewards of completing a successful financing, the most overrated are the pecuniary ones, and most underappreciated are the deep and lasting friendships that can result. I was reminded of this, vividly, on Friday. I shared a few very happy hours with the three other principals in the $10 million private equity financing we completed last November: Zheng Shulin, the owner and founder of Kehui International,  Elliott Chen, Kehui’s lawyer, and Ada Yu, a Vice President at the PE firm CRCI. 

We got together in Shenzhen to participate in a seminar at the Nanshan Venture Capital Club. The purpose was to give other entrepreneurs in Shenzhen a better understanding of the mechanics, timing and financial fundamental of pre-IPO PE investment in China. It was a very happy reunion. We hadn’t met as a group since last November. In the intervening months, Ada went on maternity leave and gave birth to twin daughters, while Mr. Zheng has been busy completing construction on the new factory in Jiangxi the PE investment enabled. The new factory will allow Kehui to more than double its output and become a dominant supplier of copper and aluminum-coated wires for use in electronics industry. 

There’s a nice symmetry here, of course: Ada’s twins and Mr. Zheng’s new factory got their starts at just about the same time last summer. That’s as far as I’ll go with the metaphor, since I’m sure Mr. Zheng will concede, despite his evident pride in his new factory, that Ada’s twins are the far more momentous creation. 

I was so happy and so moved by the whole experience on Friday, of being back together with Mr. Zheng, Elliott and Ada, and having a chance to “re-live” some of the experience in front of a crowd of about 70 at the seminar. Mr. Zheng shared one of the nicest stories from the closing: we were stuck at the final hurdle for over a month, waiting for government financial regulators in Jiangxi. They’d never before been asked to approve a foreign investment of this scale in their province, and so didn’t really know the rules or how to apply them. It looked like Jiangxi’s approval process could take months, and so cost Mr. Zheng the chance to get the new factory underway and meet surging orders. 

Mr. Zheng camped out in Nanchang, Jiangxi’s capital, to try to persuade the government officials.  I decided to visit CRCI’s office in Hong Kong to work out an agreement to advance the money ahead of the government’s final approval. CRCI’s partner agreed to do so, even though it could increase their risk in the deal. At the same moment I was dialing Mr. Zheng to give him the good news, he phoned me from Nanchang, Jiangxi’s capital, to say he’d just been given the final okay.  I returned to CRCI’s office a short time after, with Mr. Zheng, to sign the closing documents. The money arrived two weeks later.   

A big part of the credit belongs to Elliott Chen, since he both wrote the legal briefs, and spent the long hours explaining to Jiangxi officials how to apply the relevant national laws on foreign exchange transactions. A lesson here: in China, the national government in Beijing crafts very clear and often forward-thinking financial laws, but their implementation can be very hit-or-miss. Without Elliott’s work, we might still be waiting for Jiangxi Province to say Yes. 

Mr. Zheng, Elliott, Ada and I had some time to chat privately among ourselves. But, not nearly enough. Ada had to rush back to Hong Kong to take care of her twins, and the rest of us had business meetings to attend. For me, though, what most stands out is the deep feeling of friendship, forged by a common purpose to get an exceptionally talented entrepreneur the money he needed to take his business to the next level. 

While the ultimate success at Kehui will rightly belong to Mr. Zheng, all of us benefitted from our work on the financing. Elliott is now recognized as one of the best PE lawyers around. Ada is ready to resume her career at CRCI next week, knowing the Kehui investment is on track for a success as large as she could hope for. And, CFC is also on track to achieving the goal I set for it, of becoming the investment bank most proficient at capital-raising China’s best SME.

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I never much liked the term “Private Equity” since it serves two very different meanings and even more different business models. That difference has never been more stark than it is today. There is what I like to call “Big PE” and “Small PE”. One is hurting, and the other is still thriving. Luckily for China First Capital, we focus working with the part of the PE industry that’s still in good shape.  

In Big PE, large-scale, multi-billion-dollar deals are done by famous firms of the likes of Kohlberg Kravis Roberts, Blackstone and Carlyle. In Small PE , another group of PE firms thrive by finding great companies, at an earlier stage in their development, and backing them with growth capital. 

Big PE targets larger, often publicly-traded companies, or divisions of these larger firms. Using a slug of equity to support a large pile of bank debt, these private equity deals are based on acquiring a controlling interest in a company, and can deliver outstanding results by tossing out tired and underperforming management teams, tightening up on operating efficiencies, investing for growth. In 1-3 years, if things go well, the Big PE firm exits the now-improved business through either a trade sale or primary stock market listing. 

What matters most here essentially is finding a poorly-run business, with a bad capital structure and often worse management. (To take one recent example among many, think of Cerberus’s purchase of Chrysler’s from Daimler.) Ideally, a Big PE firm can turn things around quickly after buying control, and get an exit where the debt is paid off, and the underlying equity gets a very high rates of return. 

There are two big problems now in Big PE: the drying up of credit, and the shrinking valuations put on the businesses spiffed up for sale by the PE firms.  The recession compounds the problems, since the deals are built on leverage, and the bank debt will often have aggressive covenants attached to it. Those covenants (generally targeting  operating metrics like increasing EBITDA) are much harder to achieve in a down economy. Covenants get breached, deals need to be restructured with the Big PE firm pouring in more of its own capital, and the time and value of an exit go in the wrong directions: it takes longer to make less. 

Not a good business to be in at the moment. 

Then there’s Small PE, which has never looked sounder. The core skill-set here never goes out of fashion. It’s the ability to find a great company with the potential to grow far larger. Small PE firms invest their own money, for a minority stake in a business. They then provide what help they can to management, and if they’ve chosen their portfolio investments well, will wait confidently for the optimal moment to achieve a very solid return on each individual investment.  

In other words, Small PE is not built on complex financial engineering, but on good, old-fashioned “stock-picking”. 

Last month, David Rubenstein, the co-founder and managing director of Carlyle Group, one of the biggest of the Big PE,  gave a presentation in Tokyo titled “What Happened? What Will Happen? A Look At The Changing Investment And Private Equity Worlds” . Rubenstein, who has made over a billion dollars personally in the PE industry, tried to summarize all the tectonic forces destabilizing Big PE. There’s a lot of alarming stuff in his presentation. The key line: “The Credit Crisis Has Dislocated the Private Equity Industry “. (If anyone would like a copy of the Rubenstein presentation, email me at peter@chinafirstcapital.com)                                                                                                                                          

Rubenstein’s prediction, which I share: “Deals: Smaller, Less Frequent, More Overseas”. In particular, Rubenstein foresees more PE firms raising money to invest in Asia. The fact he cites: Asia private equity fundraising has increased but remains small at 9.2% of the $331 billion raised by U.S. PE funds in 2007 considering that the combined GDP of the above countries is 93% of the GDP of the U.S. 

No question, Big PE will now try to act more like Small PE. The problem they’ll face is that they’re not well structured to find, assess and invest in smaller-sized deals. My guess is that the good PE firms already operating in Asia – the ones we work with regularly at China First Capital – will  be able move quicker and smarter than their new Big PE rivals. Here I means firms like China Renaissance Capital, (www.crcicapital.com) which has a great record of finding strong middle-market companies in China, investing wisely and at fair valuations, and then working alongside management to create the operating conditions for an ideal exit. 

Rubenstein’s talk included a table showing the 2008 year-to-date performance of a number of the most well-known Big PE.  All the following have lost money this year. What you see here is a cumulative loss of many tens of billions of dollars:

􀂃 Tosca Fund – 62%

􀂃 Templeton Emerging – 50%

􀂃 Kensington/Citadel  –37%

􀂃 Satellite Overseas  -30%

􀂃 Marathon Global Equity – 20%

􀂃 Canyon Value Realiz. –20%

􀂃 Goldman Sachs Investment Partners –16%

􀂃 Deephaven Global –15%

􀂃 Millenium Global HY –14%

􀂃 Cantillon Europe –13%

􀂃 Zweig-Dimenna Intl. –8%

􀂃 Harbinger Offshore -5%

􀂃 Cerberus Intl. –3%

􀂃 Viking Global Equities –2%

The good Small PE firms are having far better years. My own prediction is that this performance gap will only widen over the next two years, as the deal pipelines for Asian PE firms we work with remain very strong. Big PE has to re-learn their approach, and try to master a new set of skills. All the while, they’ll be losing out on many of the best opportunities in Asia to their smaller, more nimble and more experienced rivals. 

It’s hard to find a dancing elephant. The reason: it’s hard to teach the elephant the steps.