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

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

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

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

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

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

Those factors are:

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

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

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

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

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

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

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

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

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

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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.

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2010 is the year China’s private equity industry hit the big time. The amount of new capital raised by PE firms reached an all-time high, exceeding Rmb150 billion (USD $23 billion). In particular, Renminbi PE funds witnessed explosive growth in 2010, both in number of new funds and amount of new capital. China’s National Social Security Fund accelerated the process of investing part of the country’s retirement savings in PE. At the same time, the country’s largest insurance companies received approval to begin investing directly in PE, which could add hundreds of billions of Renminbi in new capital to the pool available for pre-IPO investing in China’s private companies.

China First Capital has just published its third annual report on private equity in China. It is available in Chinese only by clicking here:  CFC 2011 Report. Or, you can download directly from the Research Reports section of the CFC website.

The report is illustrated with examples of Shang Dynasty bronze ware. I returned recently from Anyang, in Henan. Anyone with even a passing interest in these early Chinese bronze wares should visit the city’s splendid Yinxu Museum.

This strong acceleration of the PE industry in China contrasts with situation in the rest of the world. In the US and Europe, both PE and VC investments remained at levels significantly lower than in 2007. IPO activity in these areas remains subdued, while the number of Chinese companies going public, and the amount of capital raised, both reached new records in 2010. There is every sign 2011 will surpass 2010 and so widen even farther the gap separating IPO activity for Chinese companies and those elsewhere.

The new CFC report argues that China’s PE industry has three important and sustainable advantages compared to other parts of the world. They are:

1. High economic growth – at least five times higher in 2010 than the rate of gdp growth in the US and Europe
2. Active IPO market domestically, with high p/e multiples and strong investor demand for shares in newly-listed companies
3. A large reservoir of strong private companies that are looking to raise equity capital before an IPO

CFC expects these three trends to continue during 2011 and beyond. Also important is the fact that the geographic scope of PE investment in China is now extending outside Eastern China into new areas, including Western China, Shandong,  Sichuan. Previously, most of China’s PE investment was concentrated in just four provinces (Guangdong, Fujian, Zhejiang, Jiangsu) and its two major cities, Beijing and Shanghai. These areas of China now generally have lower rates of economic growth, higher labor costs and more mature local markets than in regions once thought to be backwaters.

PE investment is a bet on the future, a prediction on what customers will be buying in three to five years. That is the usual time horizon from investment to exit. China’s domestic market is highly dynamic and fast-changing. A company can go from founding to market leadership in that same 3-5 year period.  At the same time, today’s market leaders can easily fall behind, fail to anticipate either competition or changing consumer tastes.

This Schumpetrian process of “creative destruction” is particularly prevalent in China. Markets in China are growing so quickly, alongside increases in consumer spending, that companies offering new products and services can grow extraordinary quickly.  At its core, PE investment seeks to identify these “creative destroyers”, then provide them with additional capital to grow more quickly and outmaneuver incumbents. When PE firms are successful doing this, they can earn enormous returns.

One excellent example: a $5 million investment made by Goldman Sachs PE in Shenzhen pharmaceutical company Hepalink in 2007.  When Hepalink had its IPO in 2010, Goldman Sachs’ investment had appreciated by over 220 times, to a market value of over $1 billion.

Risk and return are calibrated. Technology investments have higher rates of return (as in example of Goldman Sachs’s investment in Hepalink)  as well as higher rates of failure. China’s PE industry is now shifting away from investing in companies with interesting new technologies but no revenue to PE investment in traditional industries like retail, consumer products, resource extraction.  For PE firms, this lowers the risk of an investment becoming a complete loss. Rates of return in traditional industries are often still quite attractive by international standards.

For example: A client of CFC in the traditional copper wire industry got PE investment in 2008. This company expects to have its IPO in Hong Kong later this year. When it does, the PE firm’s investment will have risen by over 10-fold.  Our client went from being one of numerous smaller-scale producers to being among China’s largest and most profitable in the industry. In capital intensive industries, private companies’ access to capital is still limited. Those firms that can raise PE money and put it to work expanding output can quickly lower costs and seize large amounts of market share.

Our view: the risk-adjusted returns in Chinese private equity will continue to outpace most other classes of investing anywhere in the world. China will remain in the vanguard of the world’s alternative investment industry for many long years to come.

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For Chinese private companies, one obstacle looms largest along the path to an IPO in China: the need to become fully compliant with China’s tax and accounting rules.  This process of becoming “规范” (or “guifan” in Pinyin)  is not only essential for any Chinese company seeking private equity and an eventual IPO, it is also often the most difficult, expensive, and tedious task a Chinese entrepreneur will ever undertake.

More good Chinese companies are shut out from capital markets or from raising private equity because of this “guifan” problem than any other reason. It is also the most persistent challenge for all of us active in the PE industry and in assisting SME to become publicly-traded businesses.

My firm has just published a Chinese-language research report on the topic, titled “民营企业上市规范问题”. You can download a copy by clicking here or from Research Reports page of the CFC website.

The report was written specifically for an audience of Chinese SME bosses, to provide them both with analysis and recommendations on how to manage this process successfully.  Our goal here (as with all of our research reports) is to provide tools for Chinese entrepreneurs to become leaders in their industry, and eventually leaders on the stock market. That means more PE capital gets deployed, more private Chinese companies stage successful exits and most important, China’s private sector economy continues its robust growth.

For English-only speakers, here’s a summary of some of the key points in the report:

1. The process of becoming “guifan” will almost always mean that a Chinese company must begin to invoice all sales and purchases, and so pay much higher rates of tax, two to three years before any IPO can take place
2. The higher tax rate will mean less cash for the business to invest in its own expansion. This, in turn, can lead to an erosion in market share, since “non-guifan” competitors will suddenly enjoy significant cost advantages
3. Another likely consequence of becoming “guifan” – significantly lower net margins. This, in turn, impacts valuation at IPO
4. The best way to lower the impact of “guifan” is to get more cash into the business as the process begins, either new bank lending or private equity. This can replenish the money that must now will go to pay the taxman, and so pump up the capital available to expansion and re-investment
5. As a general rule, most  Chinese private companies with profits of at least Rmb30mn can raise at least five times more PE capital than they will pay in increased annual taxes from becoming “guifan”. A good trade-off, but not a free lunch
6. For a PE fund, it’s necessary to accept that some of the money they invest in a private Chinese company will go, in effect, to pay Chinese taxes. But, since only “guifan” companies will get approved for a domestic Chinese IPO, the higher tax payments are like a toll payment to achieve exit at China’s high IPO valuations
7. After IPO, the company will have plenty of money to expand its scale and so, in the best cases, claw back any cost disadvantage or net margin decline during the run-up to IPO

We spend more time dealing with “guifan” issues than just about anything else in our client work. Often that means working to develop valuation methodologies that allow our clients to raise PE capital without being excessively penalized for any short-term decrease in net income caused by “guifan” process.

Along with the meaty content, the report also features fifteen images of Tang Dynasty “Sancai“ ceramics, perhaps my favorite among all of China’s many sublime styles of pottery.

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I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.

What’s Behind China’s Reverse IPOs?

A dysfunctional financial system pushes companies toward awkward deals in America.

By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.

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For Chinese entrepreneurs, there has never been a better time to become a publicly-traded company.  China’s Shenzhen Stock Exchange is now the world’s largest and most active IPO market in the world. Chinese companies are also active raising billions of dollars of IPO capital abroad, in Hong Kong and New York.

The main question successful Chinese entrepreneurs face is not whether to IPO, but where.

To help entrepreneurs make that decision, CFC has just completed a research study and published its latest Chinese language research report. The report, titled “民营企业如何选择境内上市还是境外上市” (” Offshore or Domestic IPO – Assessing Choices for Chinese SME”) analyzes advantages and disadvantages for Chinese SME  of IPO in China, Hong Kong, USA as well as smaller markets like Singapore and Korea.

The report can be downloaded from the Research Reports section of the CFC website , or by clicking here:  CFC’s IPO Difference Report (民营企业如何选择境内上市还是境外上市)

We want the report to help make the IPO decision-making process more fact-based, more successful for entrepreneurs. According to the report, there are three key differences between a domestic or offshore IPO. They are:

1. Valuation, p/e multiples
2. IPO approval process – cost and timing of planning an IPO
3. Accounting and tax rules

At first glance, most Chinese SME bosses will think a domestic IPO on the Shanghai or Shenzhen Stock Exchanges is always the wiser choice, because p/e multiples at IPO in China are generally at least twice the level in Hong Kong or US. But, this valuation differential can often be more apparent than real. Hong Kong and US IPOs are valued on a forward p/e basis. Domestic Chinese IPOs are valued on trailing year’s earnings. For a fast-growing Chinese company, getting 22X this year’s earnings in Hong Kong can yield more money for the company than a domestic IPO t 40X p/e, using last year’s earnings.

Chasing valuations is never a good idea. Stock market p/e ratios change frequently. The gap between domestic Chinese IPOs and Hong Kong and US ones has been narrowing for most of this year. Regulations are also continuously changing. As of now, it’s still difficult, if not impossible, for a domestically-listed Chinese company to do a secondary offering. You only get one bite of the capital-raising apple. In Hong Kong and US markets, a company can raise additional capital, or issue convertible debt, after an IPO.  This factor needs to be kept very much in mind by any Chinese company that will continue to need capital even after a successful domestic IPO.

We see companies like this frequently. They are growing so quickly in China’s buoyant domestic market that even a domestic IPO and future retained earnings may not provide all the expansion capital they will need.

Another key difference: it can take three years or more for many Chinese companies to complete the approval process for a domestic IPO. Will the +70X p/e  multiples now available on Shenzhen’s ChiNext market still be around then? It’s impossible to predict. Our advice to Chinese entrepreneurs is make the decision on where to IPO by evaluating more fundamental strengths and weaknesses of China’s domestic capital markets and those abroad, including differences in investor behavior, disclosure rules, legal liability.

China’s stock market is driven by individual investors. Volatility tends to be higher than in Hong Kong and the US, where most shares are owned by institutions.

One factor that is equally important for either domestic or offshore IPO: an SME will have a better chance of a successful IPO if it has private equity investment before its IPO. The transition to a publicly-listed company is complex, with significant risks. A PE investor can help guide an SME through this process, lowering the risks and costs in an IPO.

As the report emphasizes, an IPO is a financing method, not a goal by itself. An IPO will usually be the lowest-cost way for a private business to raise capital for expansion.  Entrepreneurs need to be smart about how to use capital markets most efficiently, for the purposes of building a bigger and better company.

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Soon to be the world’s largest pool of investment capital for the private equity industry, China’s National Social Security Fund will be responsible for paying the pensions of hundreds of millions of workers in China. It will eventually need trillions of dollars to do so. The good news for workers in China, the NSSF is professionally, carefully and competently run. China’s huge pool of pension cash is in safe hands.

I recently talked to the partner at a Chinese PE fund that is soon to receive some of the NSSF money. The report: the NSSF, though new to the world of private equity investment, has a process for choosing PE firms that is as rigorous as many of the world’s most sophisticated and investment managers. There are multiple levels of due diligence, including outside lawyers, accountants, and consultants who assess the investment performance and strategy of a PE firm, interview PE partners at length, and then provide the NSSF with recommendations.

The NSSF has used Singapore’s much-smaller but very well-managed Central Provident Fund as a model. Workers contribute part of their pay, and the money is then managed and invested by the government fund to achieve a solid rate of return that will provide for a reasonable monthly pay-out at retirement.

In contrast, the public pension systems in the US and much of Europe are thinly-disguised forms of taxation. The government collects money with each paycheck, promising to pay workers a monthly allowance when they retire. Cash from current workers is used to pay the pensions of those who have already retired. The system works fine when pensions are kept to a modest level and there are always many more people working then retired. Neither of these are true in Europe and the US. These pension plans have enormous unfunded liabilities that can be met only through cutting pension payments in the future, raising taxes on current workers or both. It’s grim.

China, wisely, chose a much sounder method of funding public pensions, when it began introducing state pensions over the last decade. Cash is invested for the future, not spent as soon as it arrives. A 35 year-old Chinese worker has a far better chance of collecting a decent state pension in 30 years than an American one. The US system is technically insolvent. The Chinese one is rolling in cash.

The NSSF had Rmb 777 billion ($120 billion) in assets at the end of 2009.  The assets are growing swiftly. More Chinese each year join the urban workforce, and so have a percentage of their salary handed over to the NSSF. Salaries are also rising fast, which sends more money into the pension system each year. Either by the end of this year, or certainly by next, the NSSF’s assets should surpass those of CALPERS , and become the world’s largest pension fund and largest Private Equity Limited Partner (“LP”), as investors in PE firms are called.

Though a government agency, the NSSF is managed like a private pension fund. It invests its capital in a mix of assets, to earn a reasonable, safe, risk-adjusted return to meet pension obligations in the future. Depending on NSSF’s investment performance, its assets should be approaching $500 billion within five years.

Most of the NSSF capital is invested in low-risk and low-yielding bonds. The NSSF’s target is an investment return of at least 3.5% a year. As part of the asset mix, the NSSF is also planning to invest about 10% of its capital in “alternative assets”,  mainly with private equity firms investing in China. It has already begun placing capital with PE firms, including CDH, SAIF Partners, New Horizon Fund.

The NSSF will likely commit over Rmb20 billion ($3 billion) a year in new capital to private equity in China. That dwarfs the activity of all other LPs in the world, including pension funds, insurance companies, university endowments.

As long as the NSSF maintains its professional approach to choosing PE firms to invest with, I’m confident it will earn a good rate of return on its PE investments. The better PE firms are earning returns of over 33% a year from their investments in China. Looking out twenty to thirty years in the future, state pensions in China will be more secure and more generous because of the investment in PE funds.

There is no better risk-adjusted asset class in the world today than investing in private Chinese companies. This is precisely what Chinese PE firms do. They provide growth capital to companies that are usually already large, profitable and successful.  The only constraint is capital. PE firms provide it, generally at modest valuations of around ten times current year’s profits.

In two to three years, these same companies will IPO in China at valuations of at least forty times past year’s profits. It’s an investment formula that can reliably produce returns of 500%-800% over two to three years.  Nowhere else in the world can match China, both on the number of attractive private companies to invest in, and the returns from doing so.

China’s private companies, and their millions of customers and employees,  will benefit from the capital provided to PE firms by the NSSF. China’s entire working population will eventually benefit as well, as these companies grow larger, more successful, and become valuable public companies. Profits from the successful PE investments will flow back to the NSSF, to support the retirement of millions.

Of course, a PE firm needs to know what it’s doing, how to select good companies, and also how to assist them in making a successful transition to publicly-traded businesses. The good ones do. The NSSF’s screening process is designed to determine which firms are the best, and then place money with them.

The main coin of the realm in China, as everyone knows, is “guanxi”, or the personal relations that tie people together and form the basis for most business deals. Fortunately for China’s working population, the NSSF, from what I’m told,  is guided by fiduciary principles and best practices, not personal ties, in assessing where to put the nation’s savings.  Along with the interviews and legal scrutiny, the NSSF also hires FOF firms (“Fund of Funds”) to evaluate PEs on its behalf. It’s another smart move. FOF firms have the most detailed knowledge and experience choosing good PE firms, and monitoring their performance.

The NSSF is responsible for the long-term financial security of hundreds of millions of people. It’s an awesome responsibility. By all evidence, they are doing important work, and doing it well.

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