China Private Equity

In the midst of one of the worst global recession in generations and the worst crisis in recent history in the global private equity industry, China looks like a nation blessed. Its economy in 2009 outperformed all others of any size, and the PE industry has continued, with barely a hitch,  on its path of blazingly fast growth.

In 2009, over $10 billion  of new capital was raised by PE firms for investing in Asia, with much of that targeting growth investments in China. For the first time, a significant chunk of new PE capital was raised in renminbi, a clear sign of the future direction of the industry. 

This year will almost certainly break all previous records. A good guess would be at least $20 billion in new capital is committed for PE investment in China. For the general partners of funds raising this money, the management fees alone (typically 2% of capital raised) will keep them in regal style for many years to come. 

In such cases, where money is flooding in, the universal impulse in the PE industry is to do larger and larger deals. But, in China especially, bigger deals are almost always worse deals on a risk-adjusted basis. Once you get above a $20 million investment round, the likelihood rises very steeply of a bad outcome. 

The reasons for this are mostly particular to China. The fact is that the best investment opportunities for PE in China are in fast-growing, successful private companies focused on China’s booming domestic market. There are thousands of companies like this. But, few of these great companies have the size (in terms of current revenues and profits) to absorb anything much above $10mn. 

It comes down to valuation. Even with all the capital coming in, PE firms still tend to invest at single-digit multiples on previous year’s earnings. PE firms also generally don’t wish to exceed an ownership level of 20-25% in a company. To be eligible for $20 million or more, a Chinese company must usually have last year’s profits of at least $15 million. Very few have reached that scale. Private companies have only been around in China for a relatively short time, and have only enjoyed the same legal protection of state-owned businesses since 2005. (see my earlier blog post)

Seeing this, a rational PE investor would adjust the size of its proposed investment. In most cases, that will mean an investment round of around $10 million – $15 million. But, rational isn’t exactly the guiding principle here. Instead of doing more deals in the $10 million – $15 million range, PE firms flush with cash most often look to up the ante.  Their reasoning is that they can’t increase the number of deals they do, because they all have a limited number of partners and limited time to review investment opportunities. 

This herd mentality is quite pervasive. The certain outcome: these same cash-rich PE firms will bid up the prices of any companies large enough to absorb investment rounds of $20 million or more. This process can be described as “paying more for less”, since again, there are very few great private Chinese companies with strong profit margins and growth rates, great management, bright prospects and  profits of $20 million and up. 

Some day there will be. But, it’s still too early, given the still limited time span during which private companies have been free to operate in China. There are, of course, quite a few state-owned enterprises (SOEs) with profits above $20 million. Most, however, are the antithesis of an outstanding, high-growth Chinese SME. They are usually tired, uncompetitive businesses with bloated workforces, low margins, clapped-out equipment and declining market shares. They would welcome PE investment, and are likely to get it because of this rush to do larger deals. Some SOEs might even get a new lease on life as a result of the PE capital. 

The certain losers in this process: the endowments, pension funds and other institutions who are shoveling the money into these PE firms as limited partners. They probably believe, as a result of their own credulity and some slick marketing by PE firms,  their money is going to invest in China’s best up and coming private businesses. Instead, some of their money is likely to go to where it’s most easily invested, not where it’s going to earn the highest returns. 

Bigger is clearly not better in Chinese PE. I say this even though we are fortunate enough now to have a client that is both very large and very successful. It is on track to raise as much as $100 million. It is every bit as good (if not better) than our smaller SME clients. Unlike PE firms, we don’t seek bigger deals. We just seek to work with the best entrepreneurs we can find. Most often for us, that means working for companies that are raising $10 million – $15 million, on the strength of profits last year of at least $5 million. 

Our business works by different rules than the PE firms. We aren’t using anyone else’s capital. There’s no imperative to do ever-larger deals. We have the freedom to work with companies without much considering their scale, and can instead choose those whose founders we like and respect, and whose performance is generally off-the-charts. 

The ongoing boom in PE investment in China is likely to continue for many, many years. This is due largely to the strength of the Chinese economy and of the private entrepreneurs who account for a large and growing share of all output. 

But, the push to do larger deals will cause problems down the line for the PE industry in China. It will result in capital being less efficiently allocated and returns being lower than they otherwise would be. PE firms will collect their 2% annual management fee, regardless of how well or poorly their investments perform. 

Raising private capital for PE investment in China is a good business. And, at the moment, it’s also an easier business than finding great places to invest bigger chunks of capital. 

“Risk and Reward.  They are the yin and yang of investing.”

So begins the latest of CFC’s Chinese-language research reports on risk and reward in private equity investment in China. The 18-page report (titled 风险与回报 in Chinese)  has just been published, and is downloadable via the CFC website by clicking this link:  http://www.chinafirstcapital.com/Riskandreward.pdf

The report’s goal, as stated in the introduction, is to “summarize the ways PE firms evaluate the risks of an investment opportunity so that entrepreneurs will better understand the decision-making process of PE firms, and so greatly improve the odds of succeeding in raising PE capital.” 

The report identifies five key areas of risk that private equity investors attempt to quantify, manage and where possible, mitigate: They are:

1. 1.      Market Risk
2. 2.      Execution Risk
3. 3.      Technology Risk
4. 4.      Political Risk 
5. 5.      Due Diligence Risk

As far as we know, this is the first such detailed report prepared in Chinese, specifically for Chinese entrepreneurs. It was written with input from the entire CFC team, and represents a collation of our experiences in dealing both with the founders and owners of Chinese SME and the PE firms that invest in them. 

Few, if any, Chinese entrepreneurs have experience raising private equity capital, or for that matter, answering pointed questions about their business. So, the whole PE process will often seem to them to be odd and protracted. The report aims to increase entrepreneurs’ level of understanding ahead of any PE fund-raising process. The report puts it this way: 

“ The goal of PE firms is to lower risk when they invest, not completely eliminate it. Risk is a necessary part of any profit-making activity. The basic principle of all PE investing is finding the best “risk-adjusted return” – which means, the best ratio of risk to potential future profit.”

Some strategies for entrepreneurs to lower an investor’s risk are also discussed. It’s practically impossible to fully eliminate these risks. But, an entrepreneur will have an important ally in managing them, if successful in raising PE capital. 

PE investment in China is a process in which an entrepreneur give up sole proprietorship over the risks in his business. It’s a new concept for most of them. But, the results are almost always positive. A problem shared is a problem halved. 

We hope the report contributes to the continued growth and success of the PE industry in China.

It can also be enjoyed, for entirely other reasons, by anyone who shares my love of Song Dynasty porcelains. Some beautiful examples of Jun, Guan, Ge, Yaozhou, Cizhou and Longquan ceramics are used as illustrations. 

Some examples:

Here’s an excellent article from AltAssets on the contributions of PE-backed companies in China. According to the study, Chinese firms receiving at least $20 million in private equity are leaders in contributing to job creation and economic growth in China.  

Chinese PE-backed companies have more positive social impact than listed firms 

The study compared 100 companies that received at least $20m US private equity investments between 2002 and 2006 with 2,424 publicly listed companies having major operations in China to determine their social impact.

The results of the study show that private equity firms support the development of inland provinces, contribute to foster domestic consumption, transfer management know-how to businesses in their portfolios and improve corporate governance. The study further shows that private equity-backed companies in China had a job creation rate 100 per cent higher and a profit growth rate 56 per cent higher than their publicly-listed peers during the study period of 2002 to 2008.

The survey, conducted by Bain & Company and the PE and Strategic Mergers & Acquisitions Working Group of the European Union Chamber of Commerce, also found that private equity-backed companies spent more than two-and-a-half times that of their publicly-listed counterparts on R&D.

Reflecting on their relatively stronger financial performance, private equity-backed companies yielded tax payments that grew at a 28 per cent rate compounded annually, ten percentage points higher than their benchmark peers in the study. 

Andre Loesekrug-Pietri, chairman of the European Chamber’s PE and Strategic M&A Working Group, said, “China has emerged as one of the leading destinations for private equity capital. This trend is continuing through the current turbulence.”

China is generating lots of interest in the private equity industry, with major firms setting up yuan-denominated funds in the country. Earlier this week Carlyle, the second biggest buy-out house, announced that it has signed a memorandum of understanding with Beijing city authorities to establish a fund there, to be known as the Carlyle Asia Partners RMB Fund.

http://www.altassets.net/private-equity-news/article/nz17691.html

As 2010 dawns, private equity in China is undergoing epic changes. PE in China got its start ten years ago. The founding era is now drawing to a close.  The result will be a fundamental realignment in the way private equity operates in China. It’s a change few of the PE firms anticipated, or can cope with. 

What’s changed? These PE firms grew large and successful raising and investing US dollars,  and then taking Chinese companies public in Hong Kong or New York. This worked beautifully for a long time, in large part because China’s own capital markets were relatively underdeveloped. Now, the best profit opportunities are for PE investors using renminbi and exiting on China’s domestic stock markets. Many of the first generation PE firms are stuck holding an inferior currency, and an inferior path to IPO. 

The dominant PE firms of yesterday, those that led the industry during its first decade in China, are under pressure, and some will not survive. They once generated hundreds of millions of dollars in profits. Now, these same firms seem antiquated, their methods and approach ill-suited to conditions in China. 

In the end, success in PE investing comes down to one thing: maximizing the difference between your entry and exit price. This differential will often be twice as large for investors with renminbi as those with dollars. The basic reason is that stock market valuations in China, on a current p/e basis, are over twice as high as in Hong Kong and New York – or an average of about 30 times earnings in China, compared to fifteen times earnings in Hong Kong and US. 

The gap has remained large and persistent for years. My view is that it will continue to be wide for many years to come. That’s because profits in China (in step with GDP) are growing faster than anywhere else, and Chinese investors are more willing to bid up the price of those earnings. 

For PE firms, the stark reality is: if you can’t enter with renminbi and exit in China, you cut your profit potential in half. 

If given the freedom, of course, any PE investor would choose to exit in China. The problem is, they don’t have that freedom. Only fully-Chinese companies can IPO in China. It’s not possible for Chinese companies with what’s called an “offshore structure”, meaning the ultimate holding company is based in Hong Kong, BVI, the Caymans or elsewhere outside China. Offshore companies could take in dollar investment from PE firms, swap it into renminbi to build their business in China, then IPO outside China. The PE firms put dollars in and took dollars out. That’s the way it worked, for example, for the lucky PE firms that invested in successful Chinese companies like Baidu, Suntech, Alibaba, Belle – all of which have offshore structure. 

In September 2006, the game changed. New securities laws in China made it all but impossible for Chinese companies to establish holding companies outside China. Year by year, the number has dwindled of good private companies in China with offshore structure. First generation PE firms with only dollars to invest in China have fewer good deals to chase. At the same time, the appeal of a domestic Chinese IPO has become stronger and stronger. Not only are IPO prices higher, but the stock markets in Shanghai and Shenzhen have become larger, more liquid, less prone to the kind of wild price-swings that were once a defining trait of Chinese investing. 

Of course, it’s not all sweetness and light. A Chinese company seeking a domestic IPO cannot choose its own timing. That’s up to the securities regulators. To IPO in China, a company must first apply to China’s securities market regulator, the CSRC, and once approved, join a queue of uncertain length. At present, the process can take two years or more. Planning and executing an IPO in Hong Kong or the US is far quicker and the regulatory process far more transparent. 

In any IPO, timing is important, but price is more so. That’s why, on balance, a Chinese IPO is still going to be a much better choice for any company that can manage one. 

Some of the first generation PE firms have tried to get around the legal limitations. For example, there is a way for PE firms to invest dollars into a purely Chinese company, by establishing a new joint venture company with the target Chinese firm. However, that only solves the smaller part of the problem. It remains difficult, if not impossible, for these joint venture entities to go public in China. 

For PE investors in China, if you can’t go public in Shanghai or Shenzhen, you’ve cut your potential profits in half. That’s a bad way to run a business, and a bad way to please your Limited Partners, the cash-rich pension funds, insurance firms, family offices and endowments that provide the capital for PE firms to invest.   

The valuation differential has other knock-on effects. A PE firm can afford to pay a higher price when investing in a Chinese company if it knows it can exit domestically.  That leaves more margin for error, and also allows PE firms to compete for the best deals. The only PE firms, however, with this option are those already holding renminbi. This group includes some of the best first generation PE firms, including CDH, SZVC, Legend. But, most first generation firms only have dollars, and that means they can only invest in companies that will exit outside China. 

Seeing the handwriting on the wall, many of the other first generation PE firms are now scrambling to raise renminbi funds. A few have already succeeded, including Prax and SAIF. But, raising an renminbi fund is difficult. Few will succeed. Those that do will usually only be able to raise a fraction of the amount they can raise is dollars. 

Add it up and it spells trouble – deep trouble – for many of the first generation PE firms in China. They made great money over the last ten years for themselves and their Limited Partners. But, the game is changed. And, as always in today’s China, change is swift and irreversible. The successful PE firms of the future will be those that can enter and exit in renminbi, not dollars.

The financial rule first postulated by Sir Thomas Gresham 500 years ago famously holds that “bad money drives out good”. In other words, if two different currencies are circulating together, the “bad” one will be used more frequently. By “bad”, what Gresham meant was a currency of equal face value but lower real value than its competitor. A simple way to understand it: if you had two $100 bills in your wallet, and suspected one is counterfeit and the other genuine, you’d likely try to spend the counterfeit $100 bill first, hoping you can pass it off at its nominal value. 

While it’s a bit of a stretch from Sir Thomas’s original precept, it’s possible to see a modified version of Gresham’s Law beginning to emerge in the private equity industry in China. How so? Money from some of “bad” PE investors may drive out money from “good” PE investors. If this happens, it could result in companies growing less strongly, less solidly and, ultimately, having less successful IPOs. 

Good money belongs to the PE investors who have the experience, temperament, patience, connections, managerial knowledge and financial techniques to help a company after it receives investment. Bad money, on the other hand, comes from private equity and other investment firms that either cannot or will not do much to help the companies it invests in. Instead, it pushes for the earliest possible IPO. 

Good money can be transformational for a company, putting it on a better pathway financially, operationally and strategically. We see it all the time in our work: a good PE investor will usually lift a company’s performance, and help implement long-term improvements. They do it by having operational experience of their own, running companies, and also knowing who to bring in to tighten up things like financial controls and inventory management. 

You only need to look at some of China’s most successful private businesses, before and after they received pre-IPO PE finance, to see how effective this “good money” can be. Baidu, Suntech, Focus Media, Belle and a host of the other most successful fully-private companies on the stock market had pre-IPO PE investment. After the PE firms invested, up to the time of IPO, these companies showed significant improvements in operating and financial performance. 

The problem the “good money” PEs face in China is that they are being squeezed out by other investors who will invest at higher valuations, more quickly and with less time and money spent on due diligence. All money spends the same, of course. So, from the perspective of many company bosses, these firms offering “bad money” have a lot going for them. They pay more, intrude less, demand little. Sure, they don’t have the experience or inclination to get involved improving a company’s operations. But, many bosses see that also as a plus. They are usually, rightly or wrongly,  pretty sure of themselves and the direction they are moving. The “good money” PE firms can be seen as nosy and meddlesome. The “bad money” guys as trusting and fully-supportive. 

Every week, new private equity companies are being formed to invest in China – with billions of renminbi in capital from government departments, banks, state-owned companies, rich individuals. “Stampede” isn’t too strong a word. The reason is simple: investing in private Chinese companies, ahead of their eventual IPOs, can be a very good way to make money. It also looks (deceptively) easy: you find a decent company, buy their shares at ten times this year’s earnings, hold for a few years while profits increase, and then sell your shares in an IPO on the Shanghai or Shenzhen stock markets for thirty times earnings. 

The management of these firms often have very different backgrounds (and pay structures) than the partners at the global PE firms. Many are former stockbrokers or accountants, have never run companies, nor do they know what to do to turn around an investment that goes wrong. They do know how to ride a favorable wave – and that wave is China’s booming domestic economy, and high profit growth at lots of private Chinese companies. 

Having both served on boards and run companies with outside directors and investors, I am a big believer in their importance. Having a smart, experienced, active, hands-on minority investor is often a real boon. In the best cases, the minority investors can more than make up for any value they extract (by driving a hard bargain when buying the shares) by introducing more rigorous financial controls, strategic planning and corporate governance. The best proof of this: private companies with pre-IPO investment from a “good money” PE firm tend to get higher valuations, and better underwriters, at the time of their initial public offering. 

But, the precise dollar value of “good money” investment is hard to measure. It’s easy enough for a “bad money” PE firm to claim it’s very knowledgeable about the best way to structure the company ahead of an IPO.  So, then it comes back to: who is willing to pay the highest price, act the quickest, do the most perfunctory due diligence and attach the fewest punitive terms (no ratchets or anti-dilution measures) in their investment contracts. In PE in China, bad money drives out the good, because it drives faster and looser.

Blackstone, the giant American PE firm, is now trying to raise its first renminbi fund. Its stated goal is to provide growth capital for China’s fast-growing companies. Blackstone isn’t the only international private equity firm seeking to raise renminbi to invest in China.  In fact, many of the world’s largest private equity firms, including those already investing in China using dollars, are looking to tap domestic Chinese sources for investment capital.

Dollar-based investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult, often impossible, and deals take longer to close than competing investors with access to renminbi.

Blackstone enjoys a big leg up in China over other international private equity firms looking to raise renminbi. Its largest institutional shareholder is China’s sovereign wealth fund, CIC. Knowing how to get Chinese investors to open their wallets is a skill both highly rare and highly advantageous in today’s global private equity industry.  

There are two reasons for this stampede to raise renminbi. First, more and more of the best investment opportunities in China are SME with purely domestic structure – meaning they cannot easily raise equity in any other currency except renminbi. The second reason is the most basic of all in the financial industry: if you want money, you go where there’s the most to spare. Right now, that means looking in China.   

In theory, the big international private equity companies have a lot to offer Chinese investors – principally, very long track records of successful deal-making that richly rewarded their earlier investors.

The international PE firms have more experience picking companies and exiting from them with fat gains. They also do a good job, in general, of keeping their investors informed about what they’re doing, and acting as prudent fiduciaries. 

So far so good. But, there’s one enormous problem here, one that Blackstone and others presumably don’t like talking about to prospective Chinese investors. Their main way of making money in the past is now both broken, and wholly unsuited to China. They’re trying to sell a beautiful left-hand drive Rolls-Royce to people who drive on the right. 

Blackstone, Carlyle, KKR, Cerberus and most of the other largest global private equity companies grew large, rich and powerful by buying controlling stakes in companies, using mainly money borrowed from banks. They then would improve the operating performance over several years, and make their real money by either selling the company in an M&A deal or listing it on the stock market.

The leverage (in the form of the bank borrowing) was key to their financial success. Like buying a house, the trick was to put a little money down, borrow the rest, and then pocket most of any increase in the value of the asset. 

It can be a great way to make money, as long as banks are happy to lend. They no longer are. As a result, these kinds of private equity deals – which really ought to be called by their original name of “leveraged buyouts”, have all but vanished from the financial landscape.  It was always a rickety structure, reliant as much on access to cheap bank debt as on a talent for spotting great, undervalued businesses. If proof were needed, just look at Cerberus’s disastrous takeover of Chrysler last year, which will result in likely losses for Cerberus of over $5 billion. 

In his annual letter to shareholders this year, Warren Buffett highlighted the inherent weaknesses in this form of private equity: “A purchase of a business by these [private equity] firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.” 

On their backs at home, it’s no wonder Blackstone, Carlyle, KKR are looking to expand in China, All have a presence in China, having invested in some larger deals involving mainly State-Owned Enterprises. But, to really flourish in China, these PE firms will need to hone a different set of skills: choosing solid companies, investing their own capital for a minority position, and then waiting patiently for an exit. 

There’s no legal way to use the formula that worked so well for so long in the US. In China, highly-leveraged transactions are prohibited. PE firms also, in most cases, can’t buy a controlling stake in a business. That runs afoul of strict takeover rules in China. 

I have little doubt Blackstone, KKR, Carlyle can all succeed doing these smaller, unleveraged deals in China. After all, they employ some of the smartest people on the planet. But, these firms all still have a serious preference for doing larger deals, investing at least $50mn. This is also true in China.

There are few good deals on this scale around. Very few private companies have the level of annual profits (at least $15mn) to absorb that amount of capital for a minority stake. Private companies that large have likely already had an IPO or are well along in the planning process. As for large SOEs, the good ones are mostly already public, and those that remain are often sick beyond the point of cure. In these cases, private equity investors find it tough to push through an effective restructuring plan because they don’t control a majority on the board seats. 

Result: some of the companies best-positioned to raise renminbi funds, including Blackstone, have an investment model that seems ill-suited to Chinese conditions. They may well succeed in raising money, but then what? They’ll either need to learn to do smaller deals (of $10mn-$20mn) or bear the heavy risk of making investments in the few larger deals around in China.  

Any prospective Chinese LP should be asking Blackstone and the other large global private equity firms some very searching questions about their investment models for China. True, these firms all have excellent track records, by and large. But, that past performance, based on the leveraged buyouts that went well, is of scant consequence in today’s China. What matters most is an eye for spotting great entrepreneurs, in fast-growing industries, and then offering them both capital and the knowledge that comes from building value as investors in earlier deals. 

Prediction: raising huge wads of cash in China will turn out to be easier for Blackstone and other large global PE firms than putting it to work where it will do the most good and earn the highest returns.

Despite my fourteen years living in London,  I needed to fly all the way back to that city this week, from China, to finally get a look at Westminster Central Hall, a stately stone pile across the street from the even statelier, stonier pile that is Westminster Abbey. Central Hall does double duty, both as a main meeting place for British Methodists, and also as an impressive venue for conferences, including the first meeting of the United Nations in 1946. 

This week, it was site of the annual Boao Forum for Asia International Capital Conference. I flew in to attend, and participate in a panel discussion on private equity in China. The Boao Forum is something like the more renowned Davos Forum, but with a particular focus on Asia and China. This annual meeting focused on finance and capital, and drew a large contingent of about 120 Chinese officials and businesspeople, along with an equal number of Western commercial bankers, lawyers, accountants, investors, politicians, academics and a few other investment bankers besides me. 

Central Hall is crowned by a large domed ceiling, said to be the second-largest in the world. I enjoyed sending back a brief live video feed to my China First Capital colleagues in Shenzhen, whirling my laptop camera up towards the dome, and then down to show the conference. It was also the first time any of my colleagues had seen me in a suit. 

The weather was a perfect encapsulation of British autumn climate, with blustery and frigid winds, occasional radiant sunshine and torrential rain. It was my first trip back to London in over two years, and nothing much had changed. What a contrast to China, where in two years, most major cities seem to undergo a radical facelift. 

“How can a non-Chinese invest in Chinese private company?” It was a straightforward question, by a London-based money manager, for the panel I was on. Straightforward, even obvious, but it was actually one I’d never really considered before, to my embarrassment. In my talk (see Powerpoint here: http://www.chinafirstcapital.com/blog/wp-content/uploads/2009/08/trends-in-private-equity.pdf) , I made the case about why Chinese SME are among the world’s best investment opportunities for private equity firms.  It’s an argument I’m used to making to conference audiences in China. This is the first time I’ve done so anywhere else. The question, though, made me feel a bit like a guy telling his friends about the new Porsche Carrera for sale for $8,000, but then saying, “unfortunately, you’re not allowed to buy one.” 

The reality is that it’s effectively impossible for a non-Chinese investor, other than the PE firms we regularly work with,  to buy into a great private Chinese SME. For one thing, the investor would need renminbi to do so, and there’s no legal way to obtain it, for purposes like this. Even if you found a way around that problem, you’d face an even steeper one when you wanted to exit the investment and convert your profits back into dollars or sterling. 

The money manager came up to me later, and I could see the vexation in her eyes. I had persuaded her there were great ways for investors to make money investing in SME in China. Disappointingly, her clients aren’t allowed to do so. Cold comfort was all I could offer,  pointing out the same basic problem exists for any non-Chinese seeking to buy shares quoted on the Shenzhen and Shanghai stock markets. 

It’s a reasonable bet that China eventually will liberalize its exchange rate controls and ultimately allow freer convertibility of the renminbi. But, that doesn’t exist now. As a result, financial investment in renminbi in China is, for the most part, reserved exclusively for Chinese. Unfair? It must seem that way to the sophisticated, well-paid money managers in London, who these days have few, if any,  similarly “sure fire” investment options for their clients. 

China is, itself, awash in liquidity, and sitting on a hoard of over $2 trillion in foreign exchange reserves. So, there really is no shortage of capital domestically. Allowing foreign investors in, of course, would increase the capital available to finance the growth of great companies. But,  it will also add to the mountain of foreign reserves and put more upward pressure on the renminbi. That’s the last thing Chinese authorities need at the moment. So, most of the best investment opportunities in China are likely to remain, for quite a lot longer, open only to Chinese investors. 

Overall, this is a very good time to be Chinese. By my historical reckoning, it’s the best since at least the Tang Dynasty over 1,000 years ago. China has changed out of all recognition over the last 30 years, creating enormous material and social gains. That beneficial change, if anything, is accelerating. The fact Chinese also have some of the world’s best investment opportunities to themselves is just another dividend from all this positive change. 

If I were a money manager, I’d also be asking myself “how can I get some of this?” But, I’m not a money manager, and I formulate things very differently. I’m so happy and privileged to have a chance to help some of China’s great private entrepreneurs. Me and my team invest all our waking hours and all our collective passion in this. We are rewarded daily, by the trust put in us by these entrepreneurs, and by our very small contribution to their continued success. That’s more than adequate return for me.

I guess I’m not cut out for purely financial investing. 

I’m flying back from China as I write this, and bringing with me something of great value to me personally — even if I can’t claim to recognize every character. It’s the Chinese-language report prepared by my China First Capital colleagues on how a Chinese SME can avoid the quicksand and plan a successful IPO. Built on a first draft in English of mine, it’s written specifically for Chinese SME bosses. The report is called “如何选择上市的时机和地点”. 

Download Here: 如何选择上市的时机和地点 “When & Where to IPO for Chinese SME”

We prepared the report with the explicit goal to help SME bosses make more informed decisions in capital-raising and IPO. There’s been an acute lack of reliable, well-researched information in Chinese on this topic. We hope the report will improve this “information deficit”. 

For me personally, this is the most important report we’ve prepared thus far for SME bosses. As this blog has discussed at length recently,  Chinese SMEs have been victimized disproportionately by every form of IPO indignity, from US OTCBB listings, to reverse mergers, Malaysian IPOs, SPACs and other schemes promoted by the predatory bankers, lawyers and advisors that swarm around China. 

Indeed, there are few bigger risks to a successful Chinese SME than making the wrong decision and heeding the wrong advice on where and when to IPO. 

I’d welcome feedback on the report. You can email me at ceo@chinafirstcapital.com

For those who can’t read the report in Chinese, it provides a comprehensive summary of pluses and minuses for Chinese SME of listing on the US, Hong Kong and Chinese stock markets. It also discusses at length, with several case studies,  the damage done to good Chinese SME by OTCBB listings and reverse mergers in the US. The bad examples abound. 

Even if you can’t read the Chinese, I hope you’ll consider sending it on to those active in China’s capital markets, as well as to any Chinese businessmen contemplating a public offering.  Better Chinese-language information is the strongest antiseptic to kill off the bad deals and bad dealmakers in China. So, I hope all those with a genuine interest in promoting entrepreneurship in China will help spread the word.

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The timing of IPO is the most important question for all Chinese SME preparing for a public listing. Unfortunately, the correct answer is often the one most rarely heard. Instead, many investment bankers and advisors in China tell the SME boss that an IPO should be scheduled “as soon as possible”.

This is often music to the bosses untrained ears, since they’re wrongly assuming that the proceeds of an IPO will go directly into their pockets – a misconception these same investment bankers and advisors can literally cash in on. They’ll tell the SME boss the “bad” news — that the IPO proceeds must go to the company not to his personal bank account, and that the boss won’t be able to sell any of his own shares for a year or more after the IPO – towards the end of the expensive pre-IPO planning process, when it’s usually too late to pull out, without losing a huge amount of money.

This is if they bother to mention it at all. I’ve heard of instances where the Chinese boss is never told directly by his investment bankers, lawyers and advisors, but only finds out if his staff prepares a Chinese translation of the SB-2 prospectus used in OTCBB listings.

So, if not “right away”, what is the correct answer to the question: “when should a Chinese SME IPO”? Of course, circumstances will differ for each company. But, as a general principle, an IPO should come at the apex of an SME’s growth curve, when the company is achieving its historical highest return on equity and return on investment. This way, the SME will get a fuller value for its shares when it does list them publicly.

This also explains why pre-IPO private equity can have such a key role to play in the process. The purpose: put more capital to work than the company can generate internally, or can borrow from banks. This equity capital is then invested where it will earn the highest return over a two to three year period – for example, increasing production and improving economies of scale, or accelerating the pace of opening new distribution outlets.

The PE firm will also help improve efficiencies – in their role as risk-sharing partner with the SME boss – that can lead to significant improvement in net margins. In most cases, the pre-IPO PE capital can result in a doubling of profits. Done right, the pre-IPO capital will result in only modest level of dilution for existing owners – usually no more than 25%. It’s like switching on the after-burners: the SME can speed up its growth, improve its margins, seize large available market opportunities, and so position itself for a far more successful IPO in two to three years’ time.

An IPO has one great value above everything else: it will be the cheapest and most efficient way for an SME to raise the capital it needs to expand its business. The shares will likely be valued at multiples two times higher than a pre-IPO PE investor will pay. Since the amount of capital raised will be a multiple of profits, the higher the profits at IPO the better.

To illustrate this, let’s imagine a company with profits last year of RMB75 million. It has its IPO now, at a PE of 15 and its market capitalization at IPO is RMB 1,125,000,000. The company sells 25% of its shares in the IPO, and so it raises RMB 281,250,000. If instead the company waits another year, it raises a RMB50 million of pre-IPO private equity to help push its profit growth. A year later, profits have reached RMB120 million. If the company now has its IPO, at the same PE of 15, and sells 25% of the shares, it will raise RMB450,000,000 or 60% more.

Let’s  assume  the company continues to maintain a high return-on-investment, after IPO. If so, the more money raised at IPO, the higher profits should be able grow in the future. This is perhaps the most important predictor of overall share performance after IPO. By waiting to IPO, so that its size and profits would be larger, this company will be able to raise much more at IPO and so continue generate higher profits for many years into the future.

A company can IPO only once. So, it is important to raise the optimal amount during this one IPO. If a company IPOs too early, it will sacrifice its ability to finance its growth in the future. Many of the most successful IPOs in China were for private SME companies that had pre-IPO investment from private equity companies: Baidu, Alibaba, Suntech, Belle. That isn’t a coincidence. It’s the result of the sort of smart IPO-planning that is too rare in China.

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I had the good fortune, while in LA, to have lunch recently with James Zukin. Jim is one of the name partners of the premier middle-market investment bank in the US, Houlihan Lokey Howard & Zukin. Jim and his partners were so far ahead of the curve, in spotting market opportunities, that they had to wait years for the curve even to appear behind them.

Over lunch, Jim explained how the firm stayed clear of Wall Street, both literally and figuratively, locating its headquarters in Los Angeles, and making the astute strategic decision to build a highly-focused and well-differentiated fee-based investment banking franchise, rather than an “all-purpose financial supermarket” that mixes advisory work with proprietary trading, market-making and IPO underwriting. We all know now how that supermarket model holds up over a full cycle: it doesn’t. The biggest of that breed, Merrill Lynch, sold out to Bank of America, and two other titans, Bear Sterns and Lehman Brothers, are both kaput.

Meantime, Houlihan Lokey (“HL”) has built and sustained a very successful business based first on providing fairness opinions and other valuation work, and then built up its lucrative practice advising on restructuring and M&A, and doing private placements. Even in dire financial times like now, HL continues to perform, doing solid, high-quality work a range of middle-market and SMB clients. HL again ranked as the number one firm in M&A advisory work in 2008 in deals of $2 billion or less, beating out Credit Suisse, Goldman Sachs, and others.

The race is won by the smart and focused, not the “supermarketized”.

Jim Zukin, no surprise, is the embodiment of the strategic qualities that have made his firm a consistent, anomalous success. A self-described “outsider”, he is by turns smart, charming, witty and modest. (Like me, he also likes a good burger.)

We met to talk about China, where Jim has personally spearheaded HL’s activities over the last few years, traveling back and forth frequently from LA, and opening offices in Beijing and Hong Kong. He speaks with palpable joy when discussing his visits to China. His workload at home in the US means fewer trips to China now, but he still refers to China, with heartfelt passion, as his “mistress.” It’s a description I’ve now shamelessly lifted from him, to describe my own long-term, requited love affair with China.

Jim Zukin is the one remaining “name partner” of Houlihan Lokey Howard & Zukin. He remains the chairman of Houlihan Lokey Asia. That’s a concrete sign of the company’s commitment to build a dynamic and durable business there.

HL has built a solid platform for growth in China. Its areas of expertise – and entrepreneurial outlook – position it well there. I know from my own experience that there is a sizable opportunity, to cite one example, to provide financial opinion, M&A and restructuring advisory work to the leading international PE firms active in China.

I have every reason to expect HL to succeed in China, with the same sort of approach that has worked so well for the firm in the US. How do they do it? Simple: Don’t run with the herd. Run with a better map.

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. 

A partnership at a successful Private Equity firm is one of the most rewarding, interesting, reputation-enhancing and lucrative jobs available anywhere. But, it’s not without its perils.

This was brought home rather dramatically recently. A partner I know at a China-based PE firm (one of the best, incidentally) recently found out that one of the companies he recently invested in may, in fact, be fraudulent. I didn’t ask for the details, and they weren’t volunteered. I offered my commiserations, and expressed my hope that everything would work out satisfactorily for him and his firm.  

This is not an isolated instance. Just recently, the four directors representing foreign investors’ interests in a Shenzhen-based credit company called Credit Orienwise Group, resigned from their directorships following the disappearance of its chairman, Zhang Kaiyong, in early September. Facts are still hard to come by, and may never become widely known. Credit Orienwise is a private company, and the investors are also under no obligation to disclose to the public just how much money has been lost in this fraud.  

On paper, Credit Orienwise looked to be a good company. It bills itself as one of the largest private credit guarantee companies and lenders to small and medium enterprises in Southern China.  

But, it now looks certain that some of the most experienced and well-managed PE investors in the world may have been defrauded.  

Credit Orienwise had received more than US$63 million from four of the largest and most experienced PE investors operating in Asia: the Asian Development Bank, GE Capital Equity Investments Ltd., Citigroup Venture Capital International and The Carlyle Group. It’s hard to find a business in China with a more gold-plated group of investors. Could it really be possible that all four failed in their DD to uncover any actionable evidence, or strong suspicions that would have steered them away from making the investment? And then, once having done so, where was the corporate governance?  

This looks to be a failure by investors of very dramatic proportions.  

Of course, investors – even the best – sometimes lose money. I recall someone once asking Warren Buffett for his worst investment decision. He smiled and said, “How much time do you have?”  

Markets change quickly.A management group can pursue a flawed strategy or fail to execute efficiently. All these “operational risks” are present, to some extent, in any investment. But, the risk of being defrauded is something else. It’s precisely the one risk that’s meant to be neutralized through effective DD and deal structure.  

It’s likely over 20 senior professionals – from PE firm partners to accountants and lawyers – were directly involved in the Credit Orienwise DD. Could all of them been swindled by Credit Orienwise’s Mr. Zhang? Perhaps. But, one thing is sure: those closely involved with this deal will never–should never — recover from this stain on their careers.  

Is investment fraud more widespread in China?  Circumstantial evidence might suggest so. It’s probably the biggest career threat to a PE and VC investor working in China. 

In my own experience as a VC, I’ve not had personal experience with an investment that turned out to involve fraud. I suspect this is true of most VCs and PEs. Fraud is rare, just because it is usually fairly easy to detect ahead of time – if not in the DD materials, than in the comments and character of the company’s leadership. 

Greed and prudence are the two core principles that guide the actions of a VC or PE investor. Which of these is the most important? As stories like this one involving Credit Orienwise suggest, it’s better for the PE or VC investor, especially in China, to let prudence be the final arbiter. 

To a hammer, every problem is a nail. Equally, to many fine entrepreneurs, seeing abundant opportunities for profit, the only problem is capital. Not markets. Or competition. Or industry cycles. 

In other words, good entrepreneurs usually plan big, to build big new businesses that will generate huge returns. That’s great. The only limiting factor they perceive is access to adequate capital to build big enough and fast enough to earn the largest potential return. The problem here, as we say in America, is that such an approach can be “assbackward”. Companies usually need to adjust their plans to the capital they can raise — not decouple the two entirely. 

We had a series of meetings this week with Chinese companies interested in working together with China First Capital to secure private equity funding. These meetings are usually long, detailed, and for the most part, highly enjoyable. We’re lucky to have so many outstanding companies approach China First Capital. They come from a very wide range of industries. For example, this past week, we met with one business in the high-tech synthetic fiber industry, and another that owns a large-scale sugar refinery. 

I’ve learned, over many years, first as a Forbes Magazine reporter and then as a venture capitalist, how to form a quick (and one hopes, accurate) assessment of a business’s potential. With both of these companies, the assessment is very positive. In both cases, though, the laoban clearly hadn’t thought very deeply about how much capital they both should and could raise. There was, at least at the start, this disconnect between the size of their plans, and their ability to finance them with equity capital. 

So, we needed quite a bit of time to explain things. Opportunities in business are infinite, but capital is finite resource. Investors want to achieve the highest risk-adjusted return possible. But, equally, they will determine how much capital to invest not purely, or even primarily, based on the potential return. They will also give strong consideration to issues of corporate control, valuation, ROI, even asset coverage. 

So, while investors will applaud a company with a solid plan to build a new division with annual profits of over $25mn within three years, they won’t be rushing to invest the $50mn that’s required to get there, if the current business is worth $70mn. That would require the investor, in most circumstances, to take a controlling stake in the overall business. The $50mn investment represents over 70% of the current company value. Few investors want to own that much of a portfolio company, even if they foresee great returns. 

There are all kinds of proven and effective ways to raise larger sums, two of the most common are using a mix of debt and equity, or staging the investment in tranches. The starting place for any business seeking equity finance is to ask “how much money can we best raise now?” rather than “how much money do we want to achieve most quickly our business goals?” The answer to the first determines not only which businesses opportunities a company can pursue, but at what scale. 

Capital – its cost and availability — is often among the last considerations for an entrepreneur. Part of our role as merchant bankers is to bring the entrepreneur’s plans down to earth, to keep those plans and the ability to finance them in harmony. The appropriate-sized tool for the appropriate-sized task. This idea is beautifully expressed by this ancient carved image of Chinese rice threshing machinery. 

I’m just back in Shenzhen from a visit to a client in Kunshan, near Shanghai. For me personally, it was a particularly poignant trip. 

It’s the first time I’ve been back to Jiangsu since 1982, when I left Nanjing University. Thinking as much with my stomach as my head, I immediately on arriving at 9:30pm on Wednesday night cajoled Nina, my partner, to go on a late-night search of great Jiangsu food. I eventually lost count, but by the time I left, I must have had enough xiaolongbao to feed a nursery school.

 As thoroughly enjoyable as this “Jiangsu homecoming” was, it was not even close to being the highpoint of the trip. We spent two full-days with our client, in meetings with a very select number of Private Equity firms. The meetings, from my standpoint, were truly outstanding – a text-book example of how great businesses and a great institutional investors should interact.

In fact, our client and the PE investors were, to my eye, as well-matched as this pair of Tang Dynasty horses. 

As I told one of the PE partners afterward, I’ve been in a lot of initial meetings between companies and PE or VC firms. But, never was I involved in a investment meeting that was conducted at such a uniformly high level, with both company and investor executing at the highest level of accomplishment and professionalism. 

For the PEs, this was the second-round of meetings, following earlier ones in Shenzhen, with our client’s CFO, that focused primarily on the company’s financial performance. Our client’s core leadership and ownership, however, are both based in Kunshan. So, there was even more to discuss in this second round meeting. 

For our client, this was on-the-job training. They’ve built an enormously successful business, with sales this year in excess of $120 million, and a strong likelihood of becoming, within five years, a multi-billion dollar enterprise. But, the client has done all this without equity finance, using only retained earnings and bank debt. So,  they’d never before presented themselves to sophisticated and experienced equity investors.  They don’t come any more sophisticated and experienced that these particular PE investors, with track records, both as individuals and as firms, that put them at the top of their profession. 

Our client more than exceeded our highest expectations, preparing exhaustively and answering comprehensively. 

China First Capital works to find the right investor for its clients. Not the investor offering the highest valuation, or the quickest path to IPO. We give this a lot of thought, matching the strengths of our client to the strengths of a particular PE firm. Done right, it’s transformational for both company and investor: a case of the total value created not being just larger than the sum of the parts, but exponentially so. 

It’s early yet in the process. We’re planning on several more meetings with PE firms. But, I left Kunshan even more optimistic about our client’s future, building a great partnership with a PE investor. 

It may not sound like it, but it’s meant to be my highest compliment to both our client and the PE firms we met with this week:  the xiaolongbao were good. The meetings were better. 

The world’s largest and soon-to-be second largest economies, the US and China, don’t seem at first glance to have very much in common. The USA is a new country with an old political system. It’s a little appreciated fact that the US political system, coupling a federal democracy with capitalism, is now arguably the world’s oldest, since it’s been going for 232 years without major changes. China, by contrast, is a very old country – indeed the oldest of all nation-states – but with very new, fast-evolving political and economic systems.

And yet, there are some powerful similarities, ones that appeal directly to me as a builder and financier of private companies. In terms of raw entrepreneurial talent and ambition, China and the US are all but identical. Now, granted, American and Chinese entrepreneurship can often take very different forms — the US is a mature economy that grows at a solid but hardly spectacular pace. Technology plays a key part in many of the best new entrepreneurial ideas. Think of Google or Facebook. China is booming, and every year, millions of move from subsistence farming to relative abundance, from have-nots to consumers.  Opportunities abound, in the most basic industries like agriculture and mining, all the way to biotech and semiconductors.

Even so, the entrepreneurial foundation of both China and the US is plainly, and remarkably, visible. A reverence for hard work, vigorous personal ambition, a keen eye for spotting opportunity, these are qualities shared by the people of both countries. It’s why I am so optimistic about the prospects of both countries. And also why I think that China and the US are the two best markets for private equity and venture investment. Entrepreneurship, more than capital, is what drives the process of private equity finance.

Dig still deeper, and you find other important commonalities. In both China and the US, the government does not, thankfully, cripple what my favorite economist, Gary Becker of University of Chicago, calls “the dynamic energies of the competitive private sector”. My hope and belief are that this will continue to be the case for many years to come, and that China and the US will continue to offer great opportunities for building great private companies like those we work with at China First Capital.

There’s always a conflict, in every large economy, between those who want to regulate and tax the private sector, and those who want to maximize the room for businesses to operate free of burdensome regulations and high taxation. Seen in the broadest terms, the US and China are together following one path, and Europe and Japan are following another. China and the US are still open to high-levels of commercial competition with limited government intrusion. This makes both countries more friendly toward the new ideas of entrepreneurs. Europe and Japan, by contrast, are more regulated, more taxed, more anti-competitive, and so less hospitable to the entrepreneurship that drives China and the US.

Entrepreneurs create wealth. Governments don’t. It’s a fundamental reality best understood and practiced in the US and China – and best understood, as well, by those whose capital is placed at risk in private equity deals. Capital goes to where the risk-adjusted returns are greatest. Today, that’s China and the US.

 It will be true tomorrow as well.