China Private Equity

Shenzhen’s Stock Exchange was the world’s busiest and largest IPO market during the first half of 2010. Through the end of June, 161 firms raised $22.6 billion in IPOs on Shenzhen Stock Exchange. The Shanghai Stock Exchange ranked No.4, with 11 firms raising $8.2 billion.

Take a minute to let that sink in. The Shenzhen Stock Exchange, which two years ago wasn’t even among the five largest in Asia, is now host to more new capital-raising transactions than any other stock market, including Nasdaq and NYSE. Even amid the weekly torrent of positive economic statistics from China, this one does stand out. For one thing, Shenzhen’s Stock Exchange is effectively closed to all investors from outside China. So, all those IPO deals, and the capital raised so far in 2010, were done for domestic Chinese companies using money from domestic Chinese investors.

The same goes for IPOs done on Shenzhen’s larger domestic competitor, the Shanghai Stock Exchange. In the first half of 2010, the Shanghai bourse had eleven IPOs, and raised $8.2 billion. That brings the total during the first half of 2010 in China to 172 IPOs, raising $31 billion in capital.

The total for the second half of 2010 is certain to be larger, and Shenzhen will likely lose pole position to Shanghai. The Agricultural Bank of China just completed its IPO and raised $19.2 billion in a dual listing on Shanghai and Hong Kong exchanges. Over $8.5 billion was raised from the Shanghai portion.

One reason for the sudden surge of IPOs in Shenzhen was the opening in October 2009 of a new subsidiary board, the 创业板, or Chinext market. Its purpose is to allow smaller, mainly private companies to access capital markets. Before Chinext, about the only Chinese companies that could IPO in China were ones with some degree of state ownership. Chinext changed that. There is a significant backlog of several hundred companies waiting for approval to go public on Chinext.

So far this year, 57 companies have had IPOs on Chinext. The total market value of all 93 companies listed on Chinext is about Rmb 300 billion, or 5.5% of total market capitalization of the Shenzhen Stock Exchange. On Shenzhen’s two other boards for larger-cap companies, 197 companies had IPOs during the first half of 2010.

The surge in IPO activity in China during the first half of 2010 coincided with the dismal performance overall of shares traded on the Shanghai and Shenzhen stock exchanges. Both markets are down during the first half of the year: Shanghai by over 25%  and Shenzhen by 15%. 

The IPO process in China, both on Shanghai and Shenzhen markets, is very tightly controlled by China’s securities regulator, the CSRC (证监会). It’s the CSRC that decides the number and timing of IPOs in China, not market demand. One factor the CSRC gives significant weight to is the overall performance of China’s stock market. They want to control the supply of new shares, by limiting IPO transactions, to avoid additional downward pressure on share prices overall.

So, presumably, if the Chinese stock markets performed better in the first half of 2010, the number of IPOs would have been even higher. Make no mistake: the locus of the world’s IPO activity is shifting to China.

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  

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.

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. 

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

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