China Private Equity

Private companies the world over share one common trait: a preference for paying as little tax as possible. In Italy, for example, under-reporting of taxable income by privately-owned companies is an accepted national pastime. Italy even created a special national police force, the Guardia di Finanza,  just to go after this rampant tax-cheating. They haven’t had much luck, as far as anyone can tell. 

China is no different, of course. Private companies here will try to organize their affairs in such a way that taxable income is kept as low as is plausibly possible. Business taxes are large in number and relatively high considering China is still a developing country. Corporate income taxes, for example, can reach 33% depending where you are. This is on top of a national VAT of 13%-17%, and all kinds of other assessments on wages, assets, real property. 

The usual practice is to maintain three sets of books, one for tax authorities, one for banks that show a better picture to keep the loans flowing, and the third lets the owner see the real picture. Again, this is pretty much standard practice the world over.

Public companies, of course, have far less latitude to under-report taxable income, since they undergo a properly intensive audit every year. They also have a very different incentive than private companies. A public company’s share price is usually determined by its profitability. The higher the profit, the higher the share price. Many public companies have gotten into trouble by reporting too much profit, sometimes by fabricating sales, as a way to bolster their share price. 

This opposing approach in reporting taxable income creates a very nice arbitrage opportunity investing in private Chinese companies on the road to a public listing. This tax arbitrage often turbocharges the already high risk-adjusted returns for PE investors in China. 

Here’s how it works: PE investors generally use a Price-Earnings multiple to value a company on the way in. The multiple will usually be between six and nine times last year’s profits. That’s already a little low, given how large and fast-growing these companies often are. But, the 6-9X  valuation multiple becomes more akin to highway robbery when you look at it more closely. Everyone knows, of course, that the profit number used to make this valuation calculation is understated. It’s generally based on the only set of audited returns that are available, and those are the books prepared for China’s tax authorities. 

So, if the company’s tax records show a profit last year, for example, of $5mn, it’s a reasonable assumption the real figure is anywhere from 40% to more than 100% higher. But, the the purposes of calculating valuation, only the under-reported number is used. The effect is to lower the PE multiple from 6-9x. to perhaps 3-5x.  That makes these PE investments China in a screaming bargain, assuming everything goes well, of course, after the investment. 

But, from the PE firm’s standpoint, it gets even better than being able to buy in at very low valuations. They know that a big part of the plan, after investment, will be the get the company ready for an IPO. This is usually a two to three year process that involves reporting a larger and larger percentage of the actual profit as taxable profit, since this will also be the profit number used for IPO valuation. 

For every dollar of “found” profits inside a company, the PE investor stands to make at least five extra dollars in return, based on a typical-sized investment where the PE firms buys 25% of the shares. This gain occurs even if the company does nothing after investment to increase its profits. All that’s happening is an accounting change that puts money in PE firm’s pocket. 

It’s a reasonable assumption that a Chinese company going public will get a PE multiple of 20x. (Currently, in China, the PE multiples are often twice that level.) The PE firm buys the same dollar of profits for $4, and then sells it for $20 a few years later. 

Of course, the plan will be to do even better, by putting the PE capital to work in ways that will earn a good return over the same two to three year period. So, let’s assume that profits at least double, but perhaps even triple, from the taxable- reported income the PE investor used to make this original valuation.  The IPO valuation captures not just the profit from the accounting arbitrage, but the company’s own high-octane performance after the investment. 

Add it up, and it’s not unreasonable for the PE firm to make a +300% return in only two to three years. Of course, it’ll never be seen quite this way. Instead, the PE firm will get a lot of credit for improving a company’s financial reporting and controls, and so enhancing profits. The PE firms do play a role in this. But, a lot of the profit was there to begin with. All the PE firm did was ask the company’s owner to report more of it, pay more tax, and so bring his books into alignment with public company standards. 

Now, my friends in PE firms will probably view things differently, stressing the part about the work they do after investment to improve accounting controls, and that they will never know precisely how much buried profit there is a company until after they’ve invested. It’s a basic principle of finance that there’s an information asymmetry between the owner-manager and outside shareholders.

Sometimes, not only profits are hidden, but all kinds of other unpleasantness. Both are true, and yet on balance, PE firms are getting by far the better of the deal. Their due diligence, which is both extensive and expensive, should uncover anything serious before money is committed. Once the money is invested, however, the PE firm can start benefitting from profits that remained hidden from the taxman..

Quite possibly, these have been the two toughest weeks in the history of Wall Street. Two of the largest, most well-established investment banks (Merrill and Lehman Brothers) have been shattered by losses in mortgage and derivatives markets. Two others, Goldman Sachs and Morgan Stanley, are now converting to traditional bank holding companies. Other banks are teetering, and the stock market itself has experienced some of its largest one-day losses ever. 

Amid all the change and turmoil, it’s worth remembering just what makes Wall Street so central to the world’s financial industry. The US capital markets are both the largest, and the most liquid in the world. This is no less true today than it was a month or a year ago. As important is the fact that Wall Street has developed, over the last 70 years, a set of rules, procedures and best practices for raising capital.   These have become the de facto global standard. Put another way: Wall Street rules rule. 

I’m reminded of this fact quite frequently these days. We’re in the process now, at China First Capital, of closing an investment round for one of our Chinese SME clients, from one of Asia’s most successful PE firms. The closing legal documents are weighty, running to over 300 pages in total. The governing law is Hong Kong’s. But, the actual text of many of the documents comes direct from US private equity and IPO closings, including numerous references to the “Securities Act of 1933”, the basic foundational law for share offerings done in the US since then. 

So, here we have a Chinese company obtaining equity capital from a Hong Kong-based investor, while the securities law cited is from the USA. It seems a puzzle at first, even allowing for the possibility our client may one day choose to list its shares in the USA. So, why the reliance on US law and practice? 

Quite simply, because it comes closest to striking an ideal balance between the often competing interests of management and outside shareholders. In economics terminology, this is known as the “principal-agent problem”. (For anyone who wants to read more, Wikipedia has a decent summary: http://en.wikipedia.org/wiki/Principal-agent_problem).  This describes the frequent, and often inevitable tensions that can arise between outside investors and the inside management that makes the day-to-day decisions. The management has access to far more information about a company than the providers of capital.   It’s important to keep these divergent interests aligned. That’s what a lot of US securities law assures. It does so by mandating, for example, how often board and shareholders’ meetings must be called, with what kind of notice period, and what rights an investor has to inspect the books and records of the company they’ve put money into. 

For private equity deals, the US has also evolved a series of specific protections for investors. These rules make sure, for example, that an investor has the right to sell its shares in a public offering, and to be kept fully informed during the IPO process. These are essential for the proper functioning of the global private equity industry. As you’d expect, the investor rights figure prominently in the closing documents for our client. I recognize the terms and conditions, since I’ve seen them, more or less verbatim, in PE and VC deals I’ve worked on in the US. 

So, while Wall Street may be undergoing the most far-reaching changes in several generations, it’s leadership position is unchallenged in resolving these principal-agent problems, and making the flow of capital more ample and more secure than it would be under any other legal structure.