Most investors, over time, will underperform the stock market as a whole. This is as true for people investing their own money in shares, as it is for mutual fund managers, hedge funds, PE and VC firms. So, any investor with a big sustainable “unfair” advantage should seize it.

Right now, in private equity industry in China, certain private equity firms have this unfair advantage. They get the most cash, the most good deals and the most certain exit through a domestic IPO in China. These PE firms are one part of a tripartite alliance, the likes of which the investment world has never seen.  The other two are China’s National Social Security Fund, soon to be the largest source of investible capital in the world, and the CSRC, China’s securities regulator, which has all the say in approving all domestic IPOs.

The PE firms get funding through one, and profits through the other. The deck is heavily stacked in their favor. For the hundreds of other PE firms active in China, including the global giants  TPG, KKR, Carlyle, Blackstone and Goldman Sachs,  making money investing in China is riskier, harder and slower.

Among the PE firms that are members of this new elite in China are CDH, SAIF, New Horizon,  Hony Capital. To many investment professionals outside China, these names will be unfamiliar. Yet, they operate in an environment, and achieve outcomes,  that ought to be the envy of  other investors.

The firms mainly got their start about ten years ago. They were present at the creation of the Chinese PE industry. They raised their initial capital, in most cases, from prestigious American investors, like Stanford and Princeton endowments. The firms’ investment focus has shifted somewhat over time – from technology deals to more traditional industries, from investing only dollars to now using also Renminbi. They did well almost from the beginning. This early success set in motion policies and preferences that have led more recently to their position today.

The two key developments took place within the last 18 months. First, in October 2009, China’s Shenzhen Stock Exchange launched the ChiNext （创业板）board for private companies to go public. It’s been a resounding success, with over 230 companies now listed, having raised over $5 billion from the public. Chinext’s total aggregate market cap is now over $100 billion.

The Chinext p/e multiples, from the start, have been well above levels in the US and Hong Kong. Currently, the average is 42X trailing year’s earnings. The high valuations make it a very profitable place for PE firms to exit from their investments. But, the CSRC acts as a strict gatekeeper, controlling both the number and quality of Chinese companies allowed to IPO on Chinext. Most Chinese firms who apply for Chinext listing are turned down.

The CSRC has a clear preference for companies that have received PE finance from one of the top PE firms in China, since this means, in effect, the company has already passed through a more rigorous due diligence process than the CSRC can attempt. The CSRC’s logic is impeccable: if a good PE firm was willing to put its own capital at risk when the company was private, that business should be a safer investment for public shareholders than a Chinese company without a top PE investor.

Who comes top of the CSRC’s list of favored PE firms? The firms listed above. This means that the companies invested in by these PE firms have a better chance of being chosen by the CSRC to go public on Chinext. In turn,  because of Chinext’s high valuations,  this all but guarantees these PE firms achieve better annual investment returns than others.

When the NSSF announced it was going to begin investing up to 10% of the national pension system’s capital in alternative investments, particularly PE, only a few firms were able to pass through its rigorous selection criteria. It chose firms with strong performance and high standards. Leading the list when the NSSF started handing out money last year: CDH, SAIF, New Horizon, Hony Capital.

The favored PE firms now have access to enormous capital from the state pension fund, along with what seems to be preferential access for its deals to China’s IPO market. In the future, any gains these favored PE firms have from investments using NSSF funds will flow back into higher pensions for millions of Chinese retirees. Will the CSRC consider this, when it deliberates which Chinese companies should be approved for IPO? It seems a fair assumption.

China’s pay-as-you-go pension system only got started recently. So, most of the profits from the PE deals won’t get distributed to pensioners for many years. In the meantime, the gains will be recycled back into more PE investing in domestic companies that then get preferential access to China’s capital markets. It’s a process as elegant as it is practical: Chinese investors bid up the shares at IPO, locking in high profits for a PE firms investing NSSF money. The major part of the PE’s profits is then returned to the NSSF to finance higher pension payments in the future to those same Chinese investors.

All the other PE firms outside this loop, including the global giants, will claim the system is rigged against them, that it’s harder and harder for them to compete with the favored PE firms, and to get approval for their portfolio companies to IPO in China. They probably have a point. But, in the end, this system in China will result in more private Chinese companies getting growth capital, leading to more jobs, more successful IPOs, and more comfortable retirements for China’s many millions. Those are outcomes most Chinese, as well as many others, including me, can endorse unreservedly.

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

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

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

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

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Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.

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

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

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

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

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

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

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

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

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

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

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

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

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

By one conventional measure, China’s private equity industry is still a fraction of the size of larger developed economies. The PE penetration rate calculates the total annual flow of private equity finance as a percentage of total GPD. In China, the PE penetration rate is currently 0.1% of GDP. In the US, it’s eight times larger. In the UK, the flow of PE funding 2% of GDP, or twenty times the size of China.

While this calculation of PE penetration rate correctly suggests China’s PE industry still has significant room for growth, it is also somewhat misleading. It’s an apples-and-oranges comparison. Private equity in the US and Europe is mainly used to take over large underperforming businesses or subsidiaries of big public companies. These are control investments, usually financed with heavy amounts of borrowed money and a relative sliver of equity. These deals routinely exceed $1 billion. Indeed, during the first half of this year, the ten largest PE deals, all involving US companies, had total transaction value of over $20 billion.

In China, these sort of leveraged buyout deals, for the most part,  are impossible. PE capital in China flows almost entirely into minority investments in profitable fast-growing private companies. Typical deal size is $10mn for 15%-20% of a company’s shares. Deals of this kind are far more rare in the US and UK.

The more accurate term for Private Equity investing in China is “growth capital investment.” The goal is to add fuel to a fire, providing a fast-growing company with additional capital to build new factories or expand its sales and distribution channels. This kind of investing has a far higher success rate than PE investing in the US and Europe. In China, PE firms support winners. In the rest of the world, PE firms generally try to heal the wounded.

If you measured the penetration rate of growth capital investment, I have no doubt China would now be number one in the world. Nowhere else in the world can match China in the number of great private companies that are growing by over 30% a year, have the scale, experience, management and market leadership to continue to double in size every two to three years. The only real limiting factor is a shortage of capital. That’s where PE firms come in. They invest, monitor, then exit a few years later through an IPO.

That’s another big difference between PE in China and the rest of the world. PE investors in China don’t work nearly as hard as they do elsewhere. In China, the hardest part is finding good companies and then agreeing on the size and valuation of an investment. After that, it’s usually smooth sailing. In the US and Europe, it’s not only difficult to find good investment opportunities. The big challenge begins after an investment is made, in designing and then implementing often complex, risky restructuring plans, including a lot of hiring and firing.

With so much bank borrowing involved, short-term cash-flow problems can prove fatal for the PE firm’s investment. Miss an interest payment and banks can seize the business, wiping out the PE firm’s equity investment. A notable example: Cerberus’s leveraged takeover of US automaker Chrysler. Within six months of the deal’s closing, Cerberus’s $7.4 billion investment was mainly wiped out when Chrysler’s sales plummeted.

In China, PE deals also occasionally turn sour. But, the most common reason is fraud or simple theft. PE money goes into a company and disappears, usually into personal bank account of the company’s boss. This isn’t very common. But, it does happen. The PE firm will usually have a legal right to take control of a company if its money is lost or misused. But, the legal process can be slow and the outcome uncertain. By the time a PE gains control, just about everything of value can be drained out of the company. The PE firm ends up owning 100% of a business worth far less than what they put into it.

In China, PE firms often play the role of a disciplinarian, setting up rules and doling out cash as a reward for good behavior. In the US and Europe, the PE is more like a doctor in a trauma ward.

McKinsey & Company, the global consulting firm, has estimated that China’s private equity fund penetration rate could more than quadruple in the next five years, to reach 0.5% of GDP.  If so, the annual amount of PE capital flowing into private companies could reach Rmb200 billion (US$30 billion.)  There are certainly enough good investment opportunities.

At this point, the main thing holding the industry back is a lack of strong, talented people inside PE firms. Great entrepreneurs vastly outnumber great investors in China.

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The formula for success in private equity is simple the world over: make lots of money investing other people’s money, keep 20% of the profits and pay little or no taxes on your share of the take. This tax avoidance is perfectly legal. PE firms are usually incorporated as offshore holding companies in tax-free domains like the Cayman Islands.

Depending on their nationality, partners at PE firms may need to pay some tax on the profits distributed to them individually. But, some quick footwork can also keep the taxman at bay. For example, I know PE partners who are Chinese nationals, living in Hong Kong. They plan their lives to be sure not to be in either Hong Kong or China for more than 182 days a year, and so escape most individual taxes as well. Even when they pay, it’s usually at the capital gains rate, which is generally far lower than income tax.

The tax efficiency is fundamental to private equity, and most other forms of fiduciary investing. If the PE firm’s profits were assessed with income tax ahead of distributions to Limited Partners (“LPs”), it would significantly reduce the overall rate of return, to say nothing about potentially incurring double taxation when those LPs share of profits got dinged again by the tax man.

China, as everyone in the PE world knows, is very keen to foster growth of its own homegrown private equity firms. It has introduced a raft of new rules to allow PE firms to incorporate, invest Renminbi and exit via IPO in China. So far so good. The Chinese government is also pouring huge sums of its own cash into private equity, either directly through state-owned companies and agencies, or indirectly through the country’s pay-as-you-go social security fund. (See my recent blog post here.)

Exact figures are hard to come by. But, it’s a safe bet that at least Rmb100 billion (USD$15 billion) in capital was committed to domestic private equity firms last year. This year should see even larger number of new domestic PE firms established, and even larger quadrants of capital poured in.

It’s going to be a few years yet before the successful Chinese domestic PE firms start returning significant investment profits to their investors. When they do, their investors will likely be in for something of an unpleasant surprise: the PE firms’ profits, almost certainly, will be reduced by as much as 25% because of income tax.

In other words, along with building a large homegrown PE industry that can rival those of the US and Europe, China is also determined to assess those domestic PE firms with sizable income taxes. These two policy priorities may turn out to be wholly incompatible. PE firms, more than most, have a deep, structural aversion to paying income tax on their profits. For one thing, doing so will cut dramatically into the personal profits earned by PE partners, lowering significantly the after-tax returns for these professionals. If so, the good ones will be tempted to move to Hong Kong to keep more of their share of the profits they earn investing others’ money. If so, then China could get deprived of some experienced and talented PE partners its young industry can ill afford to lose.

It’s still early days for the PE industry in China. Renminbi PE firms really only got started two years ago. I’ve yet to hear any partners of domestic PE firms complain. But, my guess is that the complaining will begin just as soon as these PE firms begin to have successful exits and begin to write very large checks to the Chinese tax bureau. What then?

China’s tax code is nothing if not fluid. New tax rules are announced and implemented on a weekly basis. Sometimes taxes go down. Most often lately, they go up.  Compared to developed countries, changing the tax code in China is simpler, speedier. So, if the Chinese government discovers that taxing PE firms is causing problems, it can reverse the policy rather quickly.

The PE firms will likely argue that taxing their profits will end up hurting hundreds of millions of ordinary Chinese whose pensions will be smaller because the PE firms’ gains are subject to tax. In industry, this is known as the “widows and orphans defense”. Chinese contribute a share of their paycheck to the state pension system, which then invests this amount on their behalf, including about 10% going to PE investment.

PE firms outside China are structured as offshore companies, with offices in places like London, New York and Hong Kong, but a tax presence in low- and no-tax domains. But, there’s currently no real way to do this in China, to raise, invest and earn Renminbi in an offshore entity. Changing that opens up an even larger can of worms, the current restrictions preventing most companies or individuals outside China from holding or investing Renminbi. This restriction plays a key part in China’s all-important Renminbi exchange rate policy, and management of the country’s nearly $2.8 trillion of foreign reserves.

The world’s major PE firms are excitedly now raising Renminbi funds. Several have already succeeded, including Carlyle and TPG. They want access to domestic investment opportunities as well as the high exit multiples on China’s stock market. When and if the income tax rules start to bite and the firm’s partners get a look at their diminished take, they may find the appeal of working and investing in China far less alluring.

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

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

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

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

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

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

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

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

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The flow of money into private equity in China is fast becoming a deluge. Six months ago, new rules were introduced to allow the country’s insurance companies to invest up to 5% of their Rmb4.8 trillion of assets in PE funds investing in China. If fully invested, that would be Rmb240 billion ($36 billion) of new capital for an investment class that is already flooded with liquidity.  Insurance assets are growing by over 15% a year, which means at least another $5 billion a year available in coming years for PE investing.

The other fire hose of capital is the National Social Security Fund (NSSF), subject of a recent blog post of mine. The NSSF is pumping Rmb80 billion ($12 billion) into PE investing in China, and expects to add an additional $1.5 billion a year in new capital for same purpose. Never before, in the space of twelve months has so much new capital poured a single class of illiquid investing.

In part, these institutions are chasing returns. Insurance companies and the NSSF both have very large longer-term liabilities, mainly in the form of retirement pensions and life insurance policies. PE investing can jazz up overall returns for institutions that otherwise park their money in safe but tepid investments like government bonds.

PE investing in China has certainly been performing well lately. The more successful firms have been earning returns of +40% a year for investors. For insurance companies, that kind of performance (40% returns on 5% of its assets) would deliver 2% base annual return. For the NSSF, with up to 10% of its assets going to PE, the potential rewards would be higher.

The investments in PE also serve a patriotic purpose. By providing additional growth capital for Chinese entrepreneurs, PE investment should help increase employment and overall economic growth in China. The insurance companies are all majority state-owned.  The NSSF is a branch of government.  Invest carefully, earn a good return and contribute to building China. That summarizes the management goals for insurance companies and the NSSF alike.

Less clear is what overall effect of all this state-controlled money on the PE industry in China. Like any other asset class, the more capital that pours in, the lower the overall returns are likely to be. The insurance companies and NSSF aren’t the only – or even the main – source of capital for the PE industry. There is already billions of dollars available for PE firms from LPs in China, the US, Europe, Japan. By some estimates, as much as $30 billion in new capital has already flowed into PE firms over the last year for investment in China. This excludes the money from the NSSF and insurance companies.

All this new capital is enough to fund PE investments in over 5,000 companies, based on a typical PE deal size in China. Are there that many good deals out there? It’s hard to say. Overall,  I’m very bullish about the number of great private companies and great PE investment opportunities in China.

The big bottleneck is certain to be within the PE firms themselves. The good ones, currently, do anywhere from 10-15 deals a year, and look seriously at another 25- 40 companies. They don’t have the partners and skilled staff to review, close and manage many more deals than this a year. The irony here: while PE firms demand portfolio companies use PE capital efficiently and scale quickly after investment, PE firms generally have no such ability. Adding capital to PE firms is like adding salt to soup.  More is not necessarily better.

As the amount of capital has surged, the preferred deal size of the more successful PE firms in China has risen steeply, from $10 million per deal, to over $25 million now. But,  in China, bigger deals are not generally better deals. Often, the opposite is true. The best PE investment I know of, for example, was the $5 million investment Goldman Sachs made in Shenzhen pharmaceutical company Hepalink. Its investment rose 240 times in value, based on Hepalink’s IPO price last year.

More capital also can also skew the priorities and tame the animal instincts of PE firms. When money is easy to raise,  as it is now, PE firms can spend more time on this than hunting for great companies. It’s easy to understand why. For every $100 million they raise, a PE firm generally keeps $2 million in annual management fees. This management fee income keeps rolling in like an annuity, regardless of how well the PE firm is doing in its “day job” of putting capital to work on behalf of investors.

Insurance companies and NSSF can generally negotiate a lower management fee. But, the incentive is still there for PE firms to focus on raising money rather than investing it.

The PE industry in China is blessed, as nowhere else is, with abundant capital, stellar investment opportunities and favorable IPO markets. My view: over the next decade, PE deals in China will produce more wealth for entrepreneurs and investors that any other major asset class anywhere in the world. Anything less will mean many opportunities in China were squandered rather than seized.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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If they gave medals for valor and distinguished service to the PE industry, SAIF’s Ben Ng surely earned one this past week. In a twelve hour stretch, he met with the laoban (Chinese for “boss”) of four different Chinese SME, at four different company headquarters, and probed each on the merits of their particular business.

The companies were at four different stages, from start-up to a 14-year-old company with a household name in much of southern China, and from four very different industries, from robotic manufacturing to a major fast-food chain, from agriculture to e-commerce.

Ben never wavered, never tired, never lost his genuine enthusiasm for hearing great entrepreneurs talk about what makes their businesses special, while explaining a little about his own company. As I found out later, Ben left a deep imprint with each entrepreneur, and in his understated way, showed each of them why SAIF is such an outstanding success in the PE industry in China, SAIF has backed more than 80 companies during its 10 year history, with $3.5 billion under management, and some of the more illustrious Limited Partners of any PE firm in the world.

By the end of the day, Ben was still full of life, mind sharp and mood upbeat. I, on the other hand, had a case of “PE battle fatigue”. I got home and almost immediately crawled into bed, trying to recall, without much success, which laoban had said what, and which business model belonged to whom. I’ve met a lot of company bosses in my 25-year career. But, I can’t recall ever having so many meetings at this high level in one day. Ben, on the other hand, mentioned he has days like this quite often, as he travels around China.

Ben is a partner at SAIF, with long experience in both high-technology and PE investing. He’s one of the professionals I most like and respect in the PE industry in China. I wanted these four laoban to meet him, and learn for themselves what top PE firms look for, how they evaluate companies, and how they work with entrepreneurs to accelerate the growth and improve the performance of their portfolio companies up to the time of an IPO, and often beyond.

Every great company needs a great investor. That about sums up the purpose and goal of my work in China.

I’d met these four laoban before and knew their businesses fairly well. In my view, each has a realistic chance to become the clear leader in their industry in China, and within a few years, assuming they get PE capital to expand, a publicly-traded company with market cap above $1 billion.  If so, they will earn the PE investor a very significant return – most likely, in excess of 500%. In other words, in my view,  a PE firm could be quite lucky to invest in these companies.

Will SAIF invest in any of the four? Hard to say. They look at hundreds of companies every year, and because of their track record, can choose from some of the very best SME in China. SAIF has as good a record as any of the top PE firms in China. According to one of Ben’s partners at SAIF, the firm has an 80% compounded annual rate of return.

That’s about as good as they get in the PE industry. SAIF’s investors might consider nominating the firm for a medal as well.

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