In an interesting discussion this week in Shenzhen with a very smart and capable lawyer (Ke Luo of Fangda Partners), I learned about a small, but growing backlash against the Top Tier private equity firms working China. Evidently there have been some articles in the Chinese press voicing criticisms of their approach and methods, and comparing them unfavorably with Chinese domestic investment companies. 

Upfront disclosure: we choose to work only with the 70 or so Top Tier private equity firms active in China, as we believe they are the best investors for companies with the greatest potential, adding more value, beyond just capital, than any other source of investment. 

A main point of contention: the ratchet and performance provisions of most of the top private equity investment deals in China (and everywhere else in the world). These are the provisions, incorporated into the final closing share purchase agreement, through which the PE firm gains greater ownership in a company they’ve invested in if the company fails to meet previously agreed revenue, profit or margin targets.   

It’s a penalty for underperformance. And a very effective and focusing one. It’s not uncommon for these ratchets provisions to specify that the PE firm can gain an additional 10-15% ownership, at no additional cost,  in a company that fails to meet the annual targets. 

In good economic times and in solidly-run companies, ratchet provisions are very rarely put into effect. So, they are a generally just a ghoulish contingent presence in every PE investment contract, the stick that compliments the carrot of a PE firm investing in your business. I know from personal experience that the concept can seem very off-putting – even frightening – to some Chinese bosses: that the PE firm will, for example, go from owning 25% of his company to 40% of his company if the owner has one year that falls below the projected levels of profit and revenue. 

We’re not in good economic times at the moment, so it’s a certainty that more ratchet provisions will be triggered this year. This is what is behind some of the complaining in the Chinese press about international PE firms. Chinese investment firms apparently don’t often include ratchet provisions. The implication of the articles is that a Chinese company is better off taking money from a Chinese investment company, and so free itself from the possibility of a sort of “takeover by stealth”, as the PE firm’s ownership ratchets upward with each year of under-target performance. 

On the surface, ratchet provisions are a very fat, very easy target. So, no surprise some in the Chinese press are attacking them. But, it’s a very incomplete, unfair – and even financially illiterate – criticism to say that because of performance ratchet provisions, a Chinese company is better off taking money from a Chinese investment company. 

Chinese investment firms may not use performance ratchets, but they have a variety of other serious weaknesses. Believe me, I’m no fan of ratchets of any kind, and work hard in negotiations with PE firms to eliminate their potential for causing harm to our clients’ businesses.  But, I still think, in almost all cases, a good Chinese private company is far better off taking money from a reputable PE firm than from a more loosely-run Chinese investment business. 

The reasons are many. But, the most deep-seated are based on an appreciation of what an outside investor can and should provide a strong Chinese SME company besides just capital. Money, famously, all spends the same. So, taking $10mn from a rich uncle or from a leading private equity firm is no different, in terms of what the money can buy – a new factory perhaps, or expanded marketing and sales, or an acquisition. 

The key difference is that the best PE firms are going to do a lot more than just write a check and then wait for the riches to flow three years later at IPO. They are going to get deeply involved assisting the company to improve all areas of its operations, implementing best practices in areas like financial accounting and corporate governance, as well as providing real expertise on hard core sales and operational issues. They also know, from past successful experience, how best to guide a private company towards a successful IPO, whether on China’s domestic stock market, or abroad.

A Chinese investment company, from what I can gather, does not have the experience, the management talent – or even the inclination – to be involved in such a detailed fashion with the companies it invests in. 

I believe, based on my own practical experience,  that the good PE firms often really do make a significant difference inside a company, enabling it to get further faster than it otherwise would. Of course, PE firms can be a pain to work with. This goes way beyond the potential for a ratchet provision to be triggered. The good PE firms act as fiduciaries for their Limited Partners, and so require a massive amount of due diligence before investing, and no less enormous information flows (generally on financial performance) after an investment is made. They want quarterly board meetings, and often hold veto rights on any spending above $500,000 or so. 

But, in return, the PE firm will go to the furthest limits of its collective abilities to make sure the Chinese company succeeds above and beyond even what the boss of that company could expect. A domestic Chinese investment company? Most likely, they have had little experience with leading good companies toward successful IPOs, little operational knowledge, little desire to commit so thoroughly to adding value inside a company. 

So, yes, performance ratchet provisions are nasty. However, they should never come into effect – if the company and the PE firm are doing everything in their power to keep the business growing. The PE firms, contrary to the way it may appear, do not  want performance ratchets triggered any more than the company’s owner does. It’s also going to reflect badly on the PE firm’s judgment and abilities, and so make it harder for them to continue to raise money for future investment.

In other words, every time a performance ratchet is triggered, it gets harder for that PE firm to continue to thrive. They would rather own a smaller share of a solid company that’s meeting its targets, than a bigger share of one that isn’t.

Following on from the publication of the China First Capital report, “2009 Private Equity and Strategic M&A Transactions in China — A Preview“ , the Chinese version is now completed. It’s more than just a change in language.

It incorporates a different but complimentary perspective to the English report, one enriched by the deep knowledge, insights and experience of my China First Capital colleague, Amy Bai. 谢谢白海鹰。

Here’s the first section. 

概  览

危机创造机遇

2008 年对于中国是不平凡的一年。2008年带给我们骄傲和欢乐，也带给我们挫折和悲伤。北京奥运会使我们感到前所未有的骄傲和自豪。刚刚战胜了冰冻灾害的我们又遭遇了汶川大地震。

从经济领域来看，2008年同样也是不平凡的一年。在年初，上海、深圳和香港的股市都出现了长势良好的喜人景象。IPO形势大好。然而，在2008年夏，股市开始暴跌 ，IPO也开始枯竭。到年底，上海、深圳和香港的股市均下跌了60%左右。 

中国的私募股权投资和风险投资出现了与股市涨跌相应的波动变化。在年初，投资活动非常活跃。上半年，私募股权投资和风险投资在中国的投资总额超过了100多亿美元。随着金融风暴的影响，私募股权投资和风险投资也放缓了在中国的投资步伐。到去年底的时候，基本上已经停止了所有投资活动。 

中国，美国和全球其他国家均以前所未有的方式采取了一系列干预措施，以期稳定经济。然而， 

当我们跨入2009年时，全球经济进入衰退期已成为不争的事实。 

大家所关心的问题是，经济复苏期何时来临？何时开始新一轮的投资比较合适？我公司愿与您们分享就上述问题的一些观点和想法。 

作为中国首创投资的董事长，凭借在资本市场，私募股权投资和商业领域20余年的经验，我经历过数次商业周期，并且成功地带领我的企业幸存了下来。例如，我曾经担任美国加州一家风险投资公司的首席执行官，目睹了网络泡沫的破灭， 当时的情形和现在类似，所有的私募股权投资活动几乎都停止了。 但是，仅仅两年以后，交易活动和企业估值又呈现回升趋势。 

所以，我们认为，就整体投资环境而言，2008年的金融风暴将会继续影响中国经济的发展，中国目前仍旧会经受各种考验。但是，对于私募股权投资、风险投资和兼并收购而言，2009年是个充满着无限机会的一年。机会与风险并存。只要你抓住了机会，成功就近在咫尺。 

2009年，企业所有人和私募股权投资公司可以期待商业主题中的下列几点。 

行业整合与“质的飞跃”

在2009年新年伊始，我们就感受到了中国经济所面临的严峻局面。经济增长速度减慢，成千的工厂倒闭和数以万计的人失业。中国许多经济领域已经出现了一种所谓“超饱和”状态，也就是很多企业在一个经济领域竞争，但是每个企业的市场份额都很小。这种情况下，中国企业进行合并的时机已经成熟。

在市场经济的自由竞争规律下，缺乏竞争力的企业会逐渐被淘汰。然而，具有竞争力的企业会不断赢取市场份额。并且，在良性循环下会不断发展壮大。产量不断提高，成本继续降低，从而，提高利润。企业将所赚取的盈余再度投到生产中以降低成本，进而形成一个良性循环。 

从消费者的角度来说，一个优秀的企业，由于其管理完善、生产效率高和销售策略适当，吸引着无数消费者。除此之外，强有力的主导品牌将会适时并购其他品牌。在这种状况下，企业间的合并已经成为不可避免的趋势。 

在中国，这种合并的势头刚刚开始。中国拥有仅次于美国的巨大的国内市场。在中国的许多纵向市场（包括金融服务，消费品，分销和物流，零售，时尚等），只要多争取一分的市场份额，销售收入就能增加上千万美元。 

通常，相对于企业所处行业，中国企业的规模都相对较小。在一些国营企业和半国营企业不占主导地位的区域，优秀民营企业抢先出击，兼并和收购其他区域内的竞争者，进而成为国内行业的领军企业。

对于投资者来说，这种帮助企业进行并购活动的机会将是空前的。企业在并购后的兴盛是投资者和企业共同期待的。即使在经济衰退期，并购案中 的优胜企业也会呈现销售收入和利润长期持续增长的现象。 

利润增长为IPO的

重现提供了平台

在过去的五年里，对于投资中国市场的私募股权投资者和风险投资者来说，IPO无疑是最可靠的退出途径。 

下面的图显示，IPO交易量在2007年达到了高峰。在2008年初，IPO交易量继续呈现高增长趋势。然而，到2008年的下半年，IPO交易量急转直下，直到2009 年年初。

众所周知， IPO市场与股票市场紧密相连。当股票市场整体表现不好时，企业发行新股票的欲望也会相应减弱。所以，只要中国股票市场和香港股票市场继续呈现薄弱趋势，IPO活动就不会呈现上升趋势。 

对于私募股权投资者和风险投资者来说，这意味着他们需要做出巨大的改变。 

为适应当前形势，私募股权投资公司和风险投资公司需要改变他们的投资方向。较之前而言，企业IPO前的短期投资机会已大大减少。换言之，私募股权投资公司或风险投资公司以18倍的估值投资于中国企业， 18个月后，再以20倍的价值发行上市的简单套利的机会已经一去不复返了。 

取而代之的是，在中国进行投资活动的私募股权投资公司应该从价值投资者的角度考虑他们在中国的投资，而不是从套利的角度去衡量他们在中国的投资。这说明了，私募股权投资公司在中国寻找目标企业时，应以企业的长远高回报为目标注入投资基金。 

企业的利润增长为中国市场的IPO重现提供了平台。具体而言，私募股权投资的重点应该集中在帮助企业提高运作效率和利润率上。 

这是一个值得强调的财务理念，尤其是在现今中国。企业估值归根结底是一个与公司盈利能力相关的函数，而不是一个投资者愿意为公司盈利能力而支付的价格函数。在市盈率倍数的公式中，“收益”部分是关键，而不是“价格”部分。在过去的五年时间里，IPO股票价格市盈率可谓差距巨大。IPO股票价格市盈率高至超过100， 低至少于5。 

对于中国市场来讲，情况可以瞬息万变。IPO股票价格市盈率很有可能出现回升趋势。什么时候会发生？我们无法给您一个准确的答案。但是我们可以确定的是，一个优秀的私募股权投资者想要投资于有明确目标和有能力实现目标的中国优秀企业。

 换言之，企业有计划和具体步骤去提升利润和利润率。那么，选择正确的中国企业进行投资，选择适当的额度进行投资和帮助企业提升整体价值，是私募股权投资公司和风险投资公司在未来几年内成功的关键所在。

 私募股权投资公司和风险投资公司提升企业价值的方式有很多。可以通过向企业提供市场营销，业务发展，金融工程，运营效率，企业治理，审计，战略兼并和收购等方面专业人才，来帮助企业迅速提高企业价值。

无论通过上述哪种方式，企业的收益都有可能被大大提高。关键点是，帮助企业保持强劲的利润增长态势。这样，在股市复苏的时候，IPO的时机再一次到来时，我们的客户企业会从中脱颖而出，赢得最高收益。 

2009年，一个有着投资重点和帮助企业成长的私募股权投资公司会脱颖而出。

AltAssets is among the world’s leading sources for news and analysis on the global private equity industry. They just published a summary of my firm‘s report, “2009 Private Equity and Strategic M&A Transactions in China — A Preview“. 

AltAssets is based in London, and provides news and research to more than 1,000 institutional investors and 2,000 private equity and venture capital firms worldwide.

Here is what they wrote about the China First Capital report:

“CHINA THE MOST ROBUST EMERGING MARKET FOR PRIVATE EQUITY AND VENTURE CAPITAL SAYS REPORT”

China continues to be the world’s most robust emerging market for private equity and venture capital finance, even in a difficult global economic environment, according to the Private Equity and Strategic M&A Transactions in China 2009 report just released by China First Capital, a boutique investment bank with offices in China, Hong Kong and the USA.

Peter Fuhrman, China First Capital’s chairman and the report’s author, said, “While the overall investment environment remains challenging and the effects of 2008’s turbulence are still being felt, 2009 will be a year of unique opportunity for private equity, venture capital and M&As in China.” 

China’s economy continues to grow, powered largely by successful small and medium private businesses, many of which are among the fastest-growing companies in the world. Private equity and venture capital investment in China will likely reach record levels in 2009, the report projects, with over $1bn in new investment into high-growth Chinese SMEs with strong focus on China’s booming domestic market. 

“In 2009, China should rightly be among the most attractive and active private equity investment markets in the world,” the China First Capital report predicts. “Many of the international private equity firms we work with are expecting to invest more in Chinese SMEs in 2009 than in 2008. Chinese companies raising capital this year will enjoy significant financial advantages over competitors, improving market share and profitability.” 

The report identifies five central trends that will drive the growth in private equity and venture capital investment in China’s SMEs in 2009. They are: the drive for industrial consolidation; profit growth helping to reignite the IPO markets for Chinese companies in China, Hong Kong and the USA; increased importance of convertible debt and other hybrid financings; opportunities for strategic M&As; well-financed businesses with strong balance sheets will enjoy sustainable competitive advantage in China’s domestic market. 

“The pathways to success in China are fewer and narrower than in recent years. But, for the entrepreneurs and private equity investors that can navigate their way in 2009, this will be a year of abundant opportunity,” Fuhrman added. 

Copyright © 2009 AltAssets

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

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

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

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

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

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

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

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

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

Not quite “a staircase to hell”, but the graphic below shows the steep fall in IPO activity in China in 2008. It looks pretty scary, doesn’t it? Chinese IPO activity in 2008 was at its lowest level since 2004. IPO activity basically came to a halt towards the end of last year. 

No one looking at the table will see much room for optimism. But, it’s worth remembering that though down by almost 80% from the year earlier, IPOs of Chinese companies in 2008 still did manage to raise $20 billion of new capital. The key thing now is that this money is used well and wisely, to build profits and market share at these now-publicly-traded Chinese companies. By doing so, these companies will provide an impetus for companies and investors to get back into the IPO market. 

In other words, the IPO market in China is most attractive vibrant not when a company sees a big price jump in its first days of trading. This does little for company, and benefits mainly those who claimed an allocation of shares ahead of the IPO. The key driver for the IPO market should be that the capital raised in an IPO is used wisely, to put companies on a higher growth path. 

Higher profits will boost company valuation, and also allow newly-listed companies to more easily raise additional equity capital in the future. As I sometimes remind the Chinese laoban we work with, “an IPO should not be just a goal in itself, but also the cheapest way to raise additional capital to build your business even faster.” 

Take the money from a public listing to make more money: that’s the quickest way in which Chinese companies can do their part for reviving the IPO market and start building again the “staircase to heaven”, with annual gains every year in the amount of money raised through IPOs. 

[netinsert=0.0.1.2.1.4.1]

That sound you just heard was the IPO window slamming shut for venture and PE-backed companies in the US. In the second quarter of this year, not a single US company went public. This is the first time this has happened since 1978, when the US VC and PE industry was 1% its current size. In other words, these are unusually tough times for the US venture and PE community.

Will China soon follow suit? Not likely, in my view. In private equity, as in so many other industries, China and the US are becoming more and more decoupled. Chinese companies will continue to go public, on the US market, as well domestically and in other Asian markets, including Hong Kong and Singapore.  I remain very optimistic about the prospects of Chinese companies now getting PE and venture finance – and no less optimistic about how well many of these investments will do for the PE firms that are investing. For Chinese companies, IPOs and other exits, including trade acquisition,  will continue, at exit values that will reward those investing at typical pre-IPO multiples in China of 6-9x last year’s earnings.

Why the different path for Chinese and US companies backed by PE and VC firms? Start with the economy. The US is going through a period of very slow growth, close to, but not yet in, a recession. This, plus the effect of high oil prices, have weighed heavily on the US stock market, which in turn, limits the appetite among investors for IPOs by US companies. IPOs are traditionally far more difficult to arrange during a time of falling stock prices.

China’s stock market – as well as those of Singapore and Hong Kong – have followed the US down. That correlation between stock markets still exists. But, even during a down market, Chinese companies can still succeed with a public offering. In Hong Kong, whose overall market has fallen by 18% so far this year, Chinese companies are still going public at a rate of about one a day.

What explains this? A big part of it, in my view, is that too much venture and equity capital in the US has gone into technology and biotech, and less to established and profitable businesses. Don’t get me wrong. The technology market in the US is great, and I’m still active in the US venture community. But,  this heavy concentration on two sectors, technology and biotech, is itself a cause of the IPO drought of 2008. Those two industries tend to be both hyper-competitive and volatile. For every Google that goes public, there are dozens of tech companies that take VC funding and then disappear without a trace. A huge percentage of the venture funding goes to early-stage businesses, with zero or limited revenues, and perhaps only some untested IP.

So, while American VCs bet heavily on two high-risk/high-reward industries, the overall stock market is made up of many different sectors, with different rates of growth, maturity and different capabilities to respond to competition. In fact, the vast majority of companies listed on the US exchanges aren’t in the technology or biotech industries.

Let’s look now at Chinese companies getting PE and VC funding and going public. They are drawn from a far wider range of industries than their US counterparts. The Chinese PE market doesn’t focus on technology companies, or biotechs, or indeed on any single industry. This is a great strength. Chinese companies getting equity finance and then an IPO exit reflect, far more broadly, the overall composition of the stock market, and so the overall investor demand.

The other key differentiator  – the Chinese economy continues to grow strongly. It’s increasingly powered by domestic consumption, and will be for decades to come. This, in itself, creates enormous opportunities for the creation of very valuable businesses serving the Chinese domestic market – example:  consumer goods and the businesses that supply those producers.  We are working with a client that manufactures a key component used in disposable diapers, a market that will likely grow by upwards of 50% a year. Fewer than 15% of China’s babies are being swaddled in disposable nappies, compared to over 90% in most middle income countries.

My conclusion – as long as private equity capital in China continues to flow into great companies in a wide variety of industries, particularly ones that service the domestic economy, the Exit Window will remain not only open, but ever-larger.