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Quietly But Successfully, US Companies Are Buying Chinese Businesses

September 14th, 2016 1 comment

--FILE--RMB (renminbi) yuan and US dollar bills are pictured at a bank in Huaibei city, east Chinas Anhui province, 16 September 2011. Chinas yuan edged down versus the dollar on Tuesday (11 October 2011), consolidating its biggest single-day gain a day earlier, brushing aside a record central bank mid-point as US lawmakers prepare to vote on a bill aimed at punishing Beijing for alleged currency manipulation. The Peoples Bank of China, the countrys central bank, set the yuan central parity rate at 6.3483 against the dollar, compared with 6.3586 on Monday.

Is China really buying up America? Or is it the opposite?

Chinese investments in the US draw lots of headlines and occasional handwringing about China’s growing influence and ownership. It is true that Chinese investors, especially SOE, have been throwing billions of dollars around, mostly for US real estate.

Far more quietly, and perhaps with better overall results, US investors have been buying businesses in China. The US acquirers do their utmost to stay out of the headlines. They prefer to shop quietly, without competitors finding out. This does a lot to keep prices down and give these US buyers maximum negotiating leverage. A lot of these US acquisitions in China stay secret long after they close.

Contrast this style with that of Chinese investors in the US. Most end up bidding against one another for the same assets. Overpaying has become a hallmark of Chinese purchases in the US.

Compared to the huge number of Chinese companies shopping for assets in the US, not nearly as many US companies are sizing up deals and kicking tires in China. Partly this stems from some misunderstandings among less-experienced US acquirers about what kinds of Chinese businesses can be targeted. Topping the list of sweeping generalizations: Chinese companies, especially privately-owned ones, are said to have owners who rarely wish to sell. Those that do, want to sell their deeply troubled companies at Neiman Marcus prices.

There is some truth to this arm-chair analysis. But, equally, there are good deals being done. I’ve written before about the most successful US acquisition in China, by food giant General Mills. (Click here to read.) It’s a textbook case of how to do M&A in China and also how to build a billion dollar business there without anyone really noticing.

Why buy rather than build in China? For one thing, China has huge and fast-growing markets in almost all industries except the smoke-stack ones. For buyers that choose and execute well, the China market is proving lucrative ground to do M&A. It’s a truth that remains a known to a select group of smart buyers.

Lifting the veil a bit, here are some of the largely-unpublicized acquisitions done by smart American buyers in China.

 

3d

In April 2015, 3D Systems, a New York Stock Exchange-quoted manufacturer of 3D printers, purchased 65% of a Chinese 3D printing sales and service company Wuxi Easyway. The Chinese company’s customers in China include VW, Nissan, Philips, Omron, Black & Decker, Panasonic and Honeywell. 3D Systems has an option to purchase the remainder of the business within five years.

Along with acquiring a developed sales network and increased distribution in China, another key aspect of the deal was to make the founder of Easyway, a Western-educated Chinese, the CEO of a newly-formed subsidiary,  3D Systems China.  The plan is to make the Chinese founder the king of a larger kingdom, a carrot frequently dangled by American companies to persuade Chinese founders to sell to them.

Since the deal closed, 3D Systems also accelerated the build-out of its operational infrastructure in China. What lies behind the deal? 3D Systems acquired a local management team as well sales channels, customer relationships.  It did not acquire manufacturing capability.

3D Systems manufactures high-quality 3D printers that sells at significantly higher prices than Chinese domestic competitors. Owning a Chinese business with established customer relationships in China will make it easier for 3D Systems to penetrate more deeply what should become the world’s largest market for 3D printers. The shift is particularly strong among Chinese private sector manufacturing companies making products for China’s consumer market.

Prior to the acquisition, Easyway was not a major client or partner of 3D Systems. As the integration moves forward, Easyway will likely expand its product offerings in China beyond relatively commoditized business of producing 3D prototypes. 3D Systems’ printers have broader capabilities, including the production of end-use parts, molds for advanced tool production, medical and surgical supplies.

The dual-track strategy is for Easyway to maintain its existing comparatively low-end service business in China while adding two new sources of revenue: the sale of 3D Systems’ 3D printers in China and an enhanced/upgraded service business of using 3D Systems printers to produce higher-quality and more complex parts to order for Chinese customers.  Both should positively impact 3D Systems’ P&L.

3D Systems used a deal structure that often works well in China. They bought a majority of Easyway, while leaving the target company founder/owner with a 35% minority stake in an illiquid subsidiary of 3D Systems. 3D Systems has the option to buy out the remaining shares and assume 100% control. But, the option may never be exercised. 3D Systems now enjoys the benefits of holding corporate control, including consolidation, while also keeping the previous owner aligned and incentivized.

The deal isn’t without its risks, of course. 3D Systems previously had no corporate presence in China. It therefore did not have its own management team in place and on-the-ground in China to manage the integration of Easyway and monitor the business going forward.

 

illinois

In July 2013, Illinois Tool Works (“ITW”), a huge and hugely-successful US industrial conglomerate, purchased 100% of a Chinese kitchen supply manufacturer Gold Pattern Holdings, based in Guangzhou, from global private equity firm Actis.

The acquisition fits well with the expansion strategy of ITW of looking to make tuck-in acquisitions in their core business segments. ITW has a large food equipment business with over $2 billion in annual revenue, 15% of ITW’s total.  Gold Pattern’s business is selling Western-style kitchen equipment to restaurants and hotels in China.

From discussions we’ve had with ITW since the acquisition, the deal is considered a solid success within ITW. The company says it has a strengthened appetite to make more such acquisitions in China, a key market for the company going forward.

ITW owns some of the most well-known brands in the food equipment industry, including Hobart mixers and Vulcan ranges. Buying Gold Pattern was part of a strategy to increase sales and distribution of these ITW brands in the fast-growing China market. Gold Pattern’s own commercial kitchen equipment is lower-priced and generally considered lower-quality.  But, the domestic sales channels used to sell Gold Pattern’s equipment is also suitable to distribute ITW’s US brands.

ITW expects that as China continues to grow more affluent, the demand among the Chinese middle class for European and American food will expand significantly. This will create a long-term market opportunity for ITW to sell Western style commercial kitchen equipment. More and more four-and-five star hotels in China are being equipped with Western kitchens as well as Chinese ones.

ITW mitigated its deal risk by buying Gold Pattern from a well-regarded international PE fund. As a result, Gold Pattern already had fully-compliant GAAP accounting, established corporate governance structures, and a professional management team. No less important, ITW knew from the outset that Gold Pattern had already successfully undergone the forensic due diligence process that preceded Actis buying control of the company. This significantly lower due diligence risk, a prime reason many deals in China – both minority and control – fail to close.

ITW has significant experience buying and integrating businesses globally. They had operations in China for twenty years prior to this acquisition.  ITW and another diversified Midwestern industrial company, Dover Corporation, are both actively, but ever-so-quietly seeking more acquisitions in China, aimed primarily at expanding their sales and distribution in China’s growing domestic market.

 

 amazon

This deal happened a long time ago, but continues to pay dividends for Amazon. In August 2004, they bought 100% of Chinese e-commerce company Joyo, paying a total of $75mn including an earn-out.  At the time, e-commerce in China was in its infancy, while Amazon was less than one-tenth its current size. The purchase of Joyo was a calculated gamble that China’s online shopping industry, despite huge impediments at the time including no established online payment systems would eventually achieve meaningful scale.

The gamble has paid off handsomely for Amazon. The e-commerce industry in China is now at least 50X larger than in 2004, with revenues last year of over $700bn. E-commerce revenues are projected to double in China by 2020. Amazon is the only non-Chinese company with meaningful market share and revenues in this hot sector. That said, Amazon is dwarfed by Alibaba’s Taobao, which has a market share in China estimated at 75%.

But, Amazon in 2012 spotted an opportunity to use its China-based business to establish a highly-lucrative cross-border business facilitating direct export sales by Chinese manufacturers and individual traders on Amazon’s main US and UK websites.  This is a business Alibaba has tried and so far failed to enter.  As a result, Amazon’s senior management, if they know no one is listening, will tell you the Joyo acquisition is a big success. It generates meaningful revenue in China (approx. $3bn), while supporting the infrastructure to build out the cross-border exports.  Amazon continues to invest aggressively in China, with enormous warehouse facilities (800,000 total sqm) and wholly-owned logistics business.

When Amazon bought Joyo, it knew full well that Chinese law, as written, forbids foreign companies from owning a domestic internet company. The Chinese government views the internet and e-commerce as “strategic national industries”. At the time, Amazon got around this by using an ownership structure for its China business called a “Variable Interest Entity” (“VIE”) also used by some domestic Chinese e-commerce companies that listed on the US stock market. The Chinese government, if they chose to, could probably shut Amazon down in China, because it’s using this loophole to operate in China. That could leave Amazon scrambling to find a way to stay in business in a country in which it now has hundreds of millions of dollars in assets.

The boards of many other large US companies would blanch at approving a deal where the assets are owned indirectly and control could be so easily forfeited by Chinese regulatory action. But, Amazon, with founder Jeff Bezos firmly in control, has shown itself time and again to be comfortable with making rather bold bets. Success in China often requires that mindset.

 

negative

Of course, US buyers have also slipped on their share of Chinese banana peels. Three well-known Silicon Valley technology companies tried and mainly failed to do M&A successfully in China. All three followed a similar strategy to acquire domestic Chinese technology companies started and owned by Chinese who had previously studied and worked in the tech field in the US. The acquisitions followed the general strategic logic of most tech M&A within the US: to identify and acquire companies with complimentary proprietary IP. But, the results in China fell well short of expectations.

The three deals were:

  1. Cirrus Logic acquired Caretta Integrated Circuits in 2007. By 2008, the acquired company was shut down and Cirrus recorded a $12mn loss.
  2. Netgear acquired CP Secure in 2008. There is now no trace of the original CP Secure business, nor any indication it is ongoing concern.
  3. Aruba Networks acquired Azalea Networks in 2010, a Chinese wireless LAN provider.

Over the last five years, no similar M&A deals in China were announced by larger Silicon Valley companies. The strategy has shifted from acquiring companies for their IP to targeting companies for their domestic Chinese distribution and sales channels.  This reflects the fact that indigenous innovation in China has not made much of a global impact. IP protection in China is still inadequate by US standards. China is also a late adopter market, which further impedes the development of globally-competitive domestic technology companies.

The successful US acquisitions in China were all rooted in a different, more viable strategy: to buy one’s way directly or indirectly into China’s burgeoning consumer market.

 

chart

 

Abridged version as published in Nikkei Asian Review

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What Alibaba Can Teach G20 Leaders — China Daily OpEd Commentary

September 6th, 2016 No comments

 

China Daily

 

 

Rural Taobao

It’s been 740 years since Hangzhou could rightly claim to be the most important city on earth. Back then, it was the capital of the world’s wealthiest and most developed nation, China during the Southern Song Dynasty. This week Hangzhou will briefly again be the center of the world’s attention and admiration, as the leaders of twenty of the world’s most developed countries arrive in the city to participate in the two-day G20 Summit.

The world’s spotlight will fall both on Hangzhou’s most famous historical landmark, West Lake, as well as its most famous local company, Alibaba, which also happens to be the world’s largest e-commerce company. Alibaba’s founder and chairman Jack Ma, is a Hangzhou native. He has spoken often of his pride that the G20 will be held in his hometown, boasting “Hangzhou has become the driving force of China’s new economy.” He suggests G20 visitors might want to rise one morning at 5am to walk about West Lake, to see Hangzhou scenery ancient and modern.

Alibaba has changed Hangzhou and changed China. But, to really grasp the full and positive extent of that change, world leaders would need to venture out from Hangzhou and visit some of China’s smallest, poorest and most remote rural villages. Here Alibaba’s impact is perhaps the most transformational. That’s because Alibaba has made a special effort to bring the benefits and convenience of online shopping to China’s rural families, the 45% of China’s population that still live on the land.

Since Alibaba listed its shares on the New York Stock Exchange in 2014, the company announced plans to spend RMB 10 billion on rural e-commerce infrastructure, to make it possible for people in over 100,000 Chinese rural villages for the first time to buy and sell on Alibaba’s Taobao marketplace.

It’s impossible to overstate the importance of this effort. E-commerce now offers the fastest and most durable way to improve living standards among China’s traditional peasants. By getting online they can shop more widely and buy more cheaply a vast range of products never before available in village China. In addition, also for the first time, they can sell directly their farm products, both fresh and packaged, to tens of millions of customers living in cities across China.

I’m one of those urban dwellers in China who now does some of his food shopping from tiny rural family businesses on Taobao. In the last week I bought dried chili peppers from Sichuan, apple vinegar from Shanxi, goji berries from Qinghai and dried sweet potato chips from Shandong. Everything I buy from rural folks is great. But, for me and probably many others, the real enjoyment comes from knowing that, thanks to Alibaba, my money can go directly to the people working hard to build a better life for themselves and their families in rural China. This, in turn, helps narrow the income gap between rural and urban.

Unlike the two big US e-commerce companies, Amazon and eBay, Alibaba takes no commission on purchases made on Taobao. This is what economists call “frictionless trade”, where buyers and sellers can transact without any middlemen taking a cut. It’s a dream of farmers worldwide, to sell products directly to customers and so earn more for their hard work.

Online shopping in rural China is now growing far faster than in cities. And yet what’s most exciting, we’re still in the early days. In the future, farmers should be able to save significant money and improve harvests by buying seeds, fertilizer and tools on Taobao and other specialized online sales platforms.

To get there, Alibaba is paying for tens of thousands of “Village Taobao” centers across China. Here, farmers can get free help to buy and sell online. Nowhere else on the planet is e-commerce being as successfully introduced into the lives of small village farmers. The world should take note, and China should take pride.

This year marks the first time China has hosted a G20 summit. Looking at the agenda, the twenty world leaders will hold detailed discussion on trade, fostering innovation and eradicating poverty. Meantime, Alibaba is busy putting such talk into action. Its efforts to spread e-commerce in China’s countryside provide concrete proof of how tech innovation can be both inclusive and helpful to all of society.

By Peter Fuhrman

The author is chairman and CEO of China First Capital.

http://www.chinadaily.com.cn/opinion/2016-09/06/content_26709314.htm

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Chinese Firms Are Reinventing Private Equity — Nikkei Asian Review

July 27th, 2016 No comments

 

Nikkei logo

Pudong

July 26, 2016  Commentary

Chinese firms are reinventing private equity

Henry Kravis, his cousin George Roberts and his mentor Jerry Kohlberg are generally credited with having invented private equity buyouts after forming KKR 40 years ago. Even after other firms like Blackstone and Carlyle piled in and deals reached mammoth scale, the rules of the buyout game changed little: Select an underperforming company, buy it with lots of borrowed money, cut costs and kick it into shape, then sell out at a big markup, either in an initial public offering or to a strategic buyer.

This has proved a lucrative business that lots of small private equity firms worldwide have sought to copy. China’s domestic buyout funds, however, are trying to reinvent the PE buyout in ways that Kravis would barely recognize. Instead of using fancy financial engineering, leverage and tight operational efficiencies to earn a return, the Chinese firms are counting on Chinese consumers to turn their buyout deals into moneymakers.

Compared to KKR and other global giants, Chinese buyout firms are tiny, new to the game and little known inside China or out. Firms such as AGIC, Golden Brick, PAG, JAC and Hua Capital have billions of dollars at their disposal to buy international companies. Within the last year, these five have successfully led deals to acquire large technology and computer hardware companies in the U.S. and Europe, including the makers of Lexmark printers, OmniVision semiconductors and the Opera web browser.

So what’s up here? The Chinese government is urgently seeking to upgrade the country’s manufacturing and technology base. The goal is to sustain manufacturing profits as domestic costs rise and sales slow worldwide for made-in-China industrial products. The government is pouring money into supporting more research and development. It is also spreading its bets by providing encouragement and sometimes cash to Chinese investment companies to buy U.S. and European companies with global brands and valuable intellectual property.

While the hope is that acquired companies will help China move out of the basement of the global supply chain, the buyout funds have a more immediate goal in sight, namely a huge expansion of the acquired companies’ sales within China.

This is where the Chinese buyout firms differ so fundamentally from their global counterparts. They aren’t focusing much on streamlining acquired operations, shaving costs and improving margins. Instead, they plan to leave things more or less unchanged at each target company’s headquarters while seeking to bolt on a major new source of revenues that was either ignored or poorly managed.

So for example, now that the Lexmark printer business is Chinese-owned, the plan will be to push growth in China and capture market share from domestic manufacturers that lack a well-known global brand and proprietary technologies. With OmniVision Technologies, the plan will be to aggressively build sales to China’s domestic mobile phone producers such as Huawei Technologies, Oppo Electronics and Xiaomi.

The China Android phone market is the biggest in the world.  Omnivision used to be the main supplier of mobile phone camera sensor chips to the Apple iPhone, but lost much of the business to Sony.

In launching last year the $1.8bn takeover of then then Nasdaq-quoted Omnivision, Hua Capital took on significant and unhedgeable risk. The deal needed the approval of the US Committee for Foreign Investment in the United States, also known as CFIUS. This somewhat-shadowy interagency body vets foreign takeovers of US companies to decide if US national security might be compromised. CFIUS has occasionally blocked deals by Chinese acquirers where the target had patents and other know-how that might potentially have non-civilian applications.

CFIUS also arrogates to itself approval rights over takeovers by Chinese companies of non-US businesses, if the target has some presence in the US. It used this justification to block the $2.8 billion takeover by Chinese buyout fund GO Scale Capital of 80% of the LED business of Netherlands-based Philips. CFIUS acted almost a year after GO Scale and Philips first agreed to the deal. All the time and money spent by GO Scale with US and Dutch lawyers, consultants and accountants to conclude the deal went down the drain. CFIUS rulings cannot be readily appealed.

Worrying about CFIUS approval isn’t something KKR or Blackstone need do, but it’s a core part of the workload at Chinese buyout funds. Hua Capital ultimately got the okay to buy Omnivision five months after announcing the deal to the US stock exchange.

The Chinese buyout firms see their role as encouraging and assisting acquired companies to build their business in China. This often boils down to business development and market access consulting. Global buyout firms say they also do some similar work on behalf of acquired companies, but it is never their primary strategy for making a buyout financially successful.

Chinese buyout funds count on two things happening to make a decent return on their overseas deals. First is a boost in revenues and profits from China. Second, the funds have to sell down their stake for a higher price than they paid. The favored route on paper has been to seek an IPO in China where valuations can be the highest in the world. This path always had its complications since it generally required a minimum three-year waiting period before submitting an application to join what is now a 900-company-long IPO waiting list.

The IPO route has gotten far more difficult this year. The Chinese government delivered a one-two punch, first scrapping its previous plan to open a new stock exchange board in Shanghai for Chinese-owned international companies, then moving to shut down backdoor market listings through reverse mergers.

The main hope for buyout funds seeking deal exits now is to sell to Chinese listed companies. In some cases, the buyout funds have enlisted such companies from the start as minority partners in their company takeovers. This isn’t a deal structure one commonly runs across outside China, but may prove a brilliant strategy to prepare for eventual exits.

There is one other important way in which the new Chinese buyout funds differ from their global peers. They don’t know the meaning of the term “hostile takeover.” Chinese buyout funds seek to position themselves as loyal friends and generous partners of a business’s current owners. A lot of sellers, especially among family-controlled companies in Europe, say they prefer to sell to a gentle pair of hands — someone who promises to build on rather than gut what they have put together. Chinese buyout funds sing precisely this soothing tune, opening up some deal-making opportunities that may be closed to KKR, Blackstone, Carlyle and other global buyout giants.

The global firms are also finding it harder to compete with Chinese buyout funds for deals within China, even though they have raised more than $10 billion in new funds over the last six years to put into investments in the country. They have basically been shut out of the game lately because they can’t and won’t bid up valuations to the levels to which domestic funds are willing to go.

The global buyout giants won’t be too concerned that they face an existential threat from their new Chinese competitors. It is also unlikely that they will adopt similar deal strategies. Instead, they are getting busy now prettying up companies they have previously bought in the U.S. and Europe. They will hope to sell some to Chinese buyers. Along with offering genial negotiations and a big potential market in China, the Chinese buyout funds are also gaining renown for paying large premiums on every deal. No one ever said that about Henry Kravis.

Peter Fuhrman is the founder, chairman and CEO of China First Capital, an investment bank based in Shenzhen.

Abridged version as published in Nikkei Asian Review

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Chinese Private Equity Funds Are Taking on the World’s Giants — Bloomberg

July 21st, 2016 No comments

Bloomberg logo

Bloomberg headline

Cathy Chan 

July 21, 2016 — 12:00 AM HKT

  • PE firms from China pursue overseas deals at record pace
  • One Italian target says China links are what matter most

 

Giuseppe Bellandi never imagined that his company, a 30-year-old maker of industrial automation components in the foothills of the Italian Alps, would end up in the hands of a private-equity fund from China.

But when the chief executive officer of Gimatic Srl realized that Asia’s largest economy was key to his firm’s future, and that Chinese PE executives had the expertise to help him grow there, Bellandi jumped at the chance to partner up. Last month, Gimatic turned down bids from Europe and the U.S. in favor of selling a majority stake to AGIC Capital, the PE firm founded by Chinese banker Henry Cai with backing from the nation’s sovereign wealth fund.

“I was really surprised when I realized how strong Chinese private equity firms are,” Bellandi said by e-mail.

China’s PE industry is expanding globally at an unprecedented pace, putting firms like AGIC, Legend Capital and Golden Brick Capital in competition with European and U.S. counterparts like never before. Fueled by China’s growing wealth, investor sophistication and desire to gain exposure to overseas assets, homegrown funds have taken part in at least $16.4 billion of cross-border deals so far this year, exceeding the previous annual record of $11 billion in 2012, according to Asian Venture Capital Journal.

The overseas push marks a coming of age for an industry that just a few years ago was better known for “buy-and-flip” investments in local companies already primed to go public. The approach was so pervasive that Chinese regulators asked KKR & Co.’s Henry Kravis, a private equity pioneer, to lecture domestic players on how to add more value.

This year, Chinese PE firms have participated in the $3.6 billion takeover of U.S. printer company Lexmark International Inc., the $2.75 billion purchase of Dutch chipmaker NXP Semiconductors NV’s standard products unit and the $600 million acquisition of Oslo-based Opera Software ASA’s web browser business. The sum of overseas transactions so far in 2016 is higher than Asian deals by foreign PE firms for the first time, according to AVCJ.

“These Chinese funds are already beginning to alter the calculus for buyout deals worldwide,” said Peter Fuhrman, the chairman and CEO of China First Capital, a Shenzhen-based investment banking and advisory firm. “It’s about buying companies that, once they have Chinese owners, can start making really big money selling products in China.”

For a QuickTake explainer China’s outbound M&A, click here.

The firepower to pull off such deals comes in part from China’s growing army of high-net worth individuals, whose ranks expanded at the fastest pace worldwide last year despite the country’s weakest economic growth in a quarter century, according to Capgemini SA. Rich Chinese investors are increasingly keen to diversify overseas after last year’s devaluation of the yuan spurred concern of more weakness to come.

“There’s a lot of domestic capital available, obviously looking for a home, and that’s fueling the emergence of these funds,” said Michael Thorneman, a partner at Bain & Co., a Boston-based consulting firm.

It’s no coincidence that the increased focus on international deals comes amid a record overseas shopping spree by Chinese companies, who have announced about $149 billion of outbound acquisitions so far this year. In some cases, PE funds are working with Chinese corporates and financial firms to help structure the deals and amplify their buying power.

For the Lexmark purchase, Legend Capital partnered with PAG Asia Capital and Apex Technology Co., a Chinese maker of ink cartridge chips. On the $9.3 billion takeover of U.S.-listed Qihoo 360 Technology Co., Golden Brick Capital teamed up with Chinese investors including Ping An Insurance (Group) Co.

Domestic Players

“PE funds like us have very experienced teams, who can do the whole thing from deal sourcing to negotiation to due diligence to deal structure,” said Parker Wang, the CEO of Beijing-based Golden Brick, which has invested about $2 billion since it opened in 2014 and also led the purchase of Opera Software’s browser unit.

It hasn’t always been smooth sailing. The Opera Software deal, for example, was originally supposed to be a takeover of the entire company, but suitors including Golden Brick failed to secure government approval.

Chinese funds are also becoming more active in their home market. They’ve been helped by a regulatory bottleneck for initial public offerings — which encouraged companies to turn to PE firms for financing — and the rise of China’s Internet industry, a business that the government shields from foreign ownership.

Local funds participated in domestic investments worth $48 billion last year, exceeding Chinese deals by foreign PE firms by a record margin, according to AVCJ. The number of active Chinese funds, at 672 during 2013-2015, was the highest in at least five years, according to data compiled by Bain & Co.

For more on one of the latest China PE investments, click here.

Among the most high-profile firms doing domestic deals is Yunfeng Capital, founded by Alibaba Group Holding Ltd. Chairman Jack Ma. The firm has purchased stakes in Citic Securities Co. and smartphone maker Xiaomi, while also participating in offers for U.S.-listed Chinese companies such as iKang Healthcare Group Inc. and WuXi PharmaTech.

Domestic funds typically have a home-field advantage over foreign firms in identifying promising investment targets, according to William Sun, general manager of Beijing Jianguang Asset Management Co., a PE firm that focuses on the technology industry.

“We’re all optimistic about China opportunities, but we probably have a better grasp of them than foreign funds,” Sun said.

To be sure, overseas players aren’t walking away from China. Some have partnered with domestic PE firms on consortium deals, as California-based Sequoia Capital did with Yunfeng on the WuXi PharmaTech takeover.

Growing Competition

Others have identified niches. KKR has spent about $1 billion on five food-related investments in China since 2008, betting that its global track record in the industry will help it thrive in a country that’s faced several food-safety scandals in recent years.

More broadly, foreign firms may be concerned about rising valuations in China, according to Bain & Co.’s Thorneman. The average PE-backed Chinese acquisition target in 2015 had an enterprise value of about 18 times earnings before interest, taxes, depreciation and amortization, up from about 11 in 2013, according to data compiled by Bain.

“There’s just more competition out there,” Thorneman said. “That translates typically into higher valuations, more competitive deals, and more players pushing prices up.”

Most signs point toward a bigger role for Chinese PE firms both at home and abroad. They controlled the largest portion of an estimated $128 billion cash pile in Asia-focused PE funds at the end of 2015, data compiled by Bain show.

Given that China is still growing faster than most major countries, any PE firm with the ability to help companies thrive there will have a leg up on international competitors, said Cai, the former Deutsche Bank AG investment banker who started AGIC last year and calls it an “Asian-European” PE firm. The fund, which counted Chinese insurance companies among its early investors, has offices in Beijing, Shanghai, Hong Kong and Munich.

“Few companies nowadays would care about the money or how much you pay them,” Cai said. “They care if the investor can help them break into the Greater China market.”

 

http://www.bloomberg.com/news/articles/2016-07-20/chinese-funds-that-kravis-urged-to-grow-up-are-now-kkr-rivals

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Can China Succeed Where the Japanese Failed Investing in US Real Estate?

July 13th, 2016 1 comment

China map

Chinese money is cascading like a waterfall into the US real estate market. Chinese institutional money, individual money, state-owned companies and private sector ones, Chinese billionaires to ordinary middle-class wage-earners, everyone wants in on the action. This year, the amount of Chinese money invested in US real estate assets is almost certain to break new records, surpassing last year’s total of over $40 billion, and continue to provide upward momentum to prices in the markets where Chinese most like to buy, the golden trio of major cities New York, Los Angeles and San Francisco, plus residential housing on both coasts.

To many, it summons up memories of an earlier period 25 years ago when it was Japanese money that flooded in, lifting prices spectacularly. For the Japanese, as we know, it all ended rather catastrophically, with huge losses from midtown Manhattan to the Monterrey Peninsula.

There is no other more important new force in US real estate than Chinese investors. Will they make the same mistakes, suffer the same losses and then retreat as the Japanese did? Certainly a lot of US real estate pros think so. There is some evidence to suggest things are moving in a similar direction.

But, there are also this year more signs Chinese are starting to adapt far more quickly to the dynamics of the US market and adjusting their strategies. They also are trying now to dissect why things went so wrong for the Japanese, to learn the lessons rather than repeat them.

This week, one of China’s leading business magazines, Caijing Magazine, published a detailed article on Chinese real estate investing in the US. I wrote it together with China First Capital’s COO, Dr. Yansong Wang. It looks at how Chinese are now assessing US real estate investing.  What kinds of investment approaches are they considering or discarding?

Here is an English version I adapted from the Chinese. It is also published this week in a widely-read US commercial real estate news website, Bisnow. The original Chinese version, as published in Caijing, can be read by clicking here.

 

——————–

headSome of the biggest investors in America’s biggest industry are certain history is repeating itself. The Americans believe that Chinese real estate investors will invest as recklessly and lose as much money as quickly in the US as Japanese real estate investors did 25 years ago. The Japanese lost – and Americans made — over ten billion dollars first selling US buildings to the Japanese at inflated prices, then buying them back at large discounts after the Japanese investors failed to earn the profits they expected.

Chinese investors are now pouring into the US to buy real estate just as the Japanese did between 1988-1993. To American eyes, it all looks very familiar. Like the Japanese, the Chinese almost overnight became one of the largest foreign buyers of US real estate. Also like the Japanese, the Chinese are mainly still targeting the same small group of assets — big, well-known office buildings and plots of land in just three cities: New York, San Francisco and Los Angeles. Pushed up by all the Chinese money, the price of Manhattan office buildings is now at a record high, above $1,400 square foot, or the equivalent of Rmb 100,000 per square meter.

The term “China price” has taken on a new meaning in the US. It used to mean that goods could be manufactured in China at least 33% cheaper. Now it means that US real estate can be sold to Chinese buyers for at least 33% more. Convincing US sellers to agree a fair price, rather than a Chinese price, takes up more time than anything else we do when representing Chinese institutional buyers in US real estate transactions.

While there are similarities between Chinese real estate investors today and Japanese investors 25 years ago, we also see some large differences. American investors should not start counting their money before its made. Based on our experience, we see Chinese investors are becoming more disciplined, more aware of the risks, more professional in evaluating US real estate.  There is still room to improve. The key to avoiding potential disaster: Chinese investors must learn the lessons of why the Japanese failed, and how to do things differently.

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Twenty-five years ago, many economists in the US believed the booming Japanese investment in US real estate was proof that Japan’s economy would soon overtake America’s as the world’s largest. Instead, we now know that Japanese buying of US property was one of the final triggers of Japanese economic collapse. The stock market, property prices both fell by over 70%. GDP shrunk, wages fell. Japanese banks, then the world’s largest, basically were brought close to bankruptcy by $700 billion in losses. To try to keep the economy from sinking even further, the Japanese government borrowed and spent at a level no other government ever has. Japan is now the most indebted country in the developed world, with total debt approaching 2.5X its gdp. There are some parallels with China’s macroeconomic condition today — banks filled with bad loans, GDP growth falling, domestic property prices at astronomical levels.

Just how much money are Chinese investors spending to buy US property? Precise data can be difficult to obtain. Many Chinese investors are buying US assets without using official channels in China to exchange Renminbi for dollars. But, the Asia Society in the US just completed the first comprehensive study of total Chinese real estate investment in the US. They estimate between 2010-2015 Chinese investors spent at least $135 billion on US property. Other experts calculate total Chinese purchases of US commercial real estate last year rose fourfold. Chinese last year became the largest buyers of office buildings in Manhattan, the world’s largest commercial real estate market.

This year is likely to see the largest amount ever in Chinese investment in the US. While most Chinese purchases aren’t disclosed, large Chinese state-owned investors, including China Life and China Investment Corporation have announced they made large purchases this year in Manhattan. While the Chinese government has recently tried to restrict flow of money leaving China, a lot of Chinese money is still reaching the US. One reason: many Chinese investors, both institutional and individual, expect the Renminbi to decline further against the dollar. Buying US property is way to profit from the Renminbi’s fall.  Other large foreign buyers of US real estate — European insurance companies, Middle East sovereign wealth funds — cannot keep up with the pace of Chinese spending.

With all this Chinese money targeting the US, many US real estate companies are in fever mode, trying to attract Chinese buyers. The large real estate brokers are hiring Chinese and preparing Chinese-language deal sheets. Some larger deals are now first being shown to Chinese investors. The reason: like the Japanese 25 years ago, Chinese investors have gained a reputation for being willing to pay prices at least 25% higher than other foreign investors and 40% above domestic US investors.

Twenty-five years ago, anyone with a building to sell at a full price flew to Japan in search of a buyer. Today, something similar is occurring. Major US real estate groups are now frequent visitors to China. Their first stop is usually the downtown Beijing headquarters of Anbang Insurance.

Eighteen months ago, just about no one in US knew Anbang’s name. Now they are among US commercial real estate owner’s ideal potential customer. The reason: last year, Anbang Insurance paid $2bn for the Waldorf Astoria Hotel. The seller was Blackstone, the world’s largest and most successful real estate investor. No one is better at timing when to buy and sell. A frequently-followed investment rule in the US Chinese investors would be wise to keep in mind:  don’t be the buyer when Blackstone is the seller.

Based on the price Anbang paid and Waldorf’s current profits, Anbang’s cap rate is probably under 2.5%. US investors generally require a cap rate of at least double that. Anbang hopes eventually to make money by converting some of the Waldorf Astoria to residential. It agreed to pay $149mn to the hotel’s union workers to get their approval to the conversion plan.

Earlier this year, Blackstone sold a group of sixteen other US hotels to Anbang for $6.5bn. Blackstone had bought the hotels three months earlier for $6bn. “Ka-Ching”.

Anbang’s chairman Wu Xiaogang now calls Blackstone chairman Steve Schwarzman his “good friend”.

 

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Another Chinese insurance company, Sunshine, paid an even higher price per room for its US hotel assets than Anbang. Sunshine paid Barry Sternlicht’s Starwood Capital Group $2 million per room for the Baccarat Hotel. It is still most ever paid for a hotel. In order to make a return above 4% a year, the hotel will need to charge the highest price per room, on average, of just about any hotel in the US.

Another famous New York hotel, the Plaza, is also now for sale. The Plaza’s Indian owners, who bought the hotel four years ago, are now facing bankruptcy. They are aggressively seeking a Chinese buyer. We’ve seen the confidential financials. Our view: only a madman should consider buying at the $700mn price the Indians are asking for.

The common view in the US now — the Chinese are, like the Japanese before, buying at the top of the cycle. Prices have reached a point where some deals no longer make fundamental economic sense. At current prices, many buildings being marketed to Chinese have negative leverage. It was similar in the late 1980s. Japanese paid so much to buy there was never any real possibility to make money except if prices continue to rise strongly. Few US investors expect them to. That’s why so many are convinced it’s a good time to sell to Chinese buyers.

No deal better symbolized the mistakes Japanese real estate investors made than the purchase in 1989 of New York’s Rockefeller Center, a group of 12 commercial buildings in the center of Manhattan. Since the time it was built by John Rockefeller in 1930, it’s been among the most famous high-end real estate projects in the world. In 1989, Mitsubishi Estate, the real estate arms of Mitsubishi Group, bought the majority of Rockefeller Center from the Rockefeller family for $1.4 billion. At the time, the Rockefeller family needed cash and they went looking for it in Japan. Mitsubishi made a preemptive bid. They bought quickly, then invested another $500mn to upgrade the building. The Japanese analysis at the time: prime Manhattan real estate on Fifth Avenue was a scarce asset that would only ever increase in value.

Mitsubishi had no real experience managing large commercial real estate projects in Manhattan. They forecasted large increases in rent income that never occurred. The idea to bring in a lot of Japanese tenants also failed. Rockefeller Center began losing money, a little at first. By 1995, with over $600 million in overdue payments to its lenders, Rockefeller Center filed for bankruptcy. Mitsubishi lost almost all its investment, and also ended up paying a big tax penalty to the US government.

A group of smart US investors took over. Today Rockefeller Center, if it were for sale, would be worth at least $8 billion.

It was a similar story with most Japanese real estate investments in the US. They paid too much, borrowed too much, made unrealistically optimistic financial projections, acted as passive landlords and focused on too narrow a group of targets in New York, San Francisco and Los Angeles.

According to Asia Society figures, over 70% of Chinese commercial real estate purchases have been in those same three cities. If you add in Silicon Valley and Orange County, the areas next to Los Angeles and San Francisco, then over 85% of Chinese investment in US real estate is going into these areas of the US. Prices in all these locations are now at highest level of all time. They are also the places where it’s hardest to get permission to build something new or change the use of the building you own.

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It’s easy enough to understand why almost all Chinese money is invested in these three places. They have the largest number of Chinese immigrants, the most flights to China, the deepest business ties to PRC companies. They are also great places for Chinese to visit or live.

But, all this doesn’t prove these are best places to invest profitably, especially for less-experienced Chinese investors. In fact, the Japanese relied on a similar local logic to justify their failed investment strategy. These are also the places with the largest number of Japanese-Americans. A quick look through financial history confirms that no two places in the world have made more money from foolish foreign investors than New York and California.

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Many of the largest US real estate groups are selling properties in New York and California to reinvest in other parts of the country where the financial returns and overall economy are better. Most of the gdp and job growth in the US comes from states in the South, especially Texas, Arizona and Florida.

Chinese investors should consider following the US smart money and shift some of their focus to these faster-growing markets. Another good strategy — partner with an experienced US real estate investor. The Japanese never did this and paid a very high price trying to learn how to buy, rent and manage profitably real estate in the US. In their most recent deals in Manhattan, both Fosun and China Life have chosen well-known US partners.

Another important difference: Japanese real estate investment in the US was almost entirely done by that country’s banks, insurance companies and developers.  With Chinese, the biggest amount of money is from individuals buying residential property. According to the Asia Society report, last year, Chinese spent $28.6bn buying homes in the US. That’s more than double the amount Chinese institutional investors spent buying commercial property. Residential prices, in most parts of the US, have still not returned to their levels before the financial crash of 2008.

Another big pool of Chinese money, almost $10bn last year, went into buying US real estate through the US government-administered EB-5 program. In the last two years, 90% of the EB-5 green cards went to Chinese citizens.

The original intention of the EB-5 program was to increase investment and jobs in small companies in America’s poorest urban and rural districts. Instead, some major US real estate developers, working with their lawyers, created loopholes that let them use the EB-5 program as a cheap way to raise capital to finance big money-making projects in rich major cities, mainly New York, Chicago and Los Angeles.  Congress is now deciding if it should reform or kill the EB-5 program.

Chinese are by far the largest source of EB5- cash. Even so, Chinese should probably be happy to see the EB-5 program either changed or eliminated. There’s also been a lot of criticism about the unethical way some EB5 agents operate within China. They are paid big fees by US developers to find Chinese investors and persuade them to become EB-5 investors. Many of these agents never properly inform Chinese investors that once they get a Green Card, they have to pay full US taxes, even if they continue to live in China. The concept of worldwide taxation is an alien one for most Chinese.

Taxes play a huge role in deciding who will and will not make money investing in US real estate. All foreign investors, including Chinese, start at a disadvantage. They aren’t treated equally. They need to pay complicated withholding tax called FIRPTA whenever they sell property, either commercial or residential. To make sure the tax is paid, the US rules require the buyer to pay only 85% of the agreed price to a foreign seller, and pay the rest directly to the IRS.  The foreign seller only gets this 15% if they can convince the IRS they’ve paid all taxes owed.

Many larger real estate investors in the US use a REIT structure to buy and manage property. It can reduce taxes substantially. Up to now, few Chinese investors have set up their own REITs in the US. They should.

Another key difference between Japanese and Chinese investors: it is very unlikely that Chinese will ever, as the Japanese did between 1995-2000, sell off most of what they own in the US. The Chinese investors we work with have a long-term view of real estate investing in the US. They say they are prepared stay calm and steadfast, even if prices either flatten out or start to fall.

This long-term view actually gives Chinese investors a competitive advantage in the US. If the US real estate industry has a weakness, it is that too few owners like to buy and hold an asset for 10 years or longer.  Many, like Blackstone and GGP, are listed companies and so need to keep up a quick pace of buying and selling to keep investors happy. As a result, there are some long-term opportunities available to smart Chinese investors that could provide steady returns even if there is no big increase in overall real estate prices.

Two examples: The US, like China, is becoming a country with a large percentage of people 65 years and older. As the country ages, American biotech and pharmaceutical companies, the world’s largest, are spending more each year to develop drugs to treat chronic diseases old people suffer from, like dementia and Parkinson’s. There’s a growing shortage of new, state-of-the-art biotech research facilities. The buildings need special construction and ventilation that require significantly higher upfront cost than building an ordinary office building. They also need to be located in nice areas, with large comfortable offices for 800 – 1,500 management and researchers. The total cost to build a biotech center is usually between $200mn-$400mn. But, rents are higher, leases are longer and there are usually tax subsidies available.

 

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The other good way to make long-term money investing in US real estate is to take advantage of the fact American companies, unlike Chinese ones, do not like owning much real estate. It tends to hurt their stock market valuation. So, bigger US companies often build long-term partnerships with reliable real estate developers to act as landlord.   Starbucks is still growing quickly and is always interested to find more real estate partners to build and own dozens of outlets for them. Starbucks provides the design and often chooses the locations. It is happy to sign a 15-20-year lease that gives landlords a rate of return or 7%-8.% a year,  higher if the developer borrows money to buy and build the new Starbucks shops. The only risk if at some point in the next 10-20 years the 2%-3% of the US population that buy a coffee at Starbucks every day stop coming.

The Japanese never developed a similar long-term strategy to make money investing in US real estate. Instead, they just spent and borrowed money to buy famous buildings they thought would only go up in value. They not only lost money, they lost face. After staying away for 20 years, Japanese investors, mainly insurance companies, have just begun investing again in New York City.

Japanese investors arrived 30 years ago confident they would be as successful buying real estate in the US as they were selling cars and tvs there. They learned a bitter lesson and left with their confidence shattered. Chinese can, should and must do better

 

(Charts courtesy Asia Society and National Association of Realtors)

 

As published by Bisnow

财经杂志 《美国房地产投资负面清单》

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Investors rush to fund China tech start-ups — Singapore Straits Times

June 28th, 2016 No comments

 Straits Times

 Investors rush to fund China tech start-ups

Staff at Beijing-based tech start-up ABD Entertainment. Many such firms have been drawing substantial investments from the government and venture capitalists, even amid China's slowing economy.
Staff at Beijing-based tech start-up ABD Entertainment. Many such firms have been drawing substantial investments from the government and venture capitalists, even amid China’s slowing economy.

Amid flow of money, hopeful entrepreneurs warned that innovation is crucial to success

Former media man Lei Ming has programmers, budding actresses and even an Internet celebrity on staff at his data-driven start-up in Beijing.

His two-year-old firm focuses on using big data and analytics – a relatively new tech sector worldwide – to help consumer brands figure out how to get the best bang for their marketing buck.

“There’s an immense amount of data we can glean from weibo accounts,” said Mr Lei, referring to the Chinese version of Twitter, which now has 261 million monthly active users.

Through data analysis, he aims to help clients find the most cost-effective ways to sell their products – through celebrity endorsement, product placement or other innovative means, especially on online platforms.

Valued at about 100 million yuan (S$20 million), the start-up received nearly 10 million yuan in funding last year.

While Mr Lei, 34, is not anxious about revenue for now, he is very clear that he must focus on making his start-up profitable. “It is important that we must be able to make money on our own instead of relying on investors’ money,” he said.

The next step is to become a major player in entertainment advertising – a market he estimates is worth 100 billion yuan. In three years, he aims to get the firm listed on a stock exchange. Mr Lei’s start-up is one of millions that have sprung up in China in recent years amid a tech startup boom. According to a report on the China.org.cn government website, some 4.9 million new companies were set up between March 2014 and May last year, with more than half being Internet firms.

Despite a slowing economy, tech start-ups of all sizes are attracting billions of dollars in investment funds from the government and venture capitalists.

According to research firm Preqin, private investors had poured around US$26.2 billion (S$35 billion) into 796 Chinese tech firms as of the middle of this month.

And last year, government-backed venture funds targeted at tech start-ups raised about 1.5 trillion yuan, increasing the amount under management to 2.2 trillion yuan, according to a Bloomberg report. However, regulations and market practices have yet to be finalised, and it is unclear how quickly the funds will be deployed, said the report.

Even though many of these 780 government guidance funds have been around for more than 10 years, the tech investment boom started after Chinese Premier Li Keqiang rolled out his “Internet Plus” initiative in 2014, encouraging innovation and entrepreneurship. This comes as China seeks to move away from a reliance on low-end manufacturing and heavy industries.

With labour and living costs on the rise, China can no longer rely on labour-intensive industries to keep its economy humming, said Ms Jenny Lee, a Shanghai-based venture capitalist who has been investing in Chinese tech firms for the past 15 years. “The old way of throwing labour at tasks is over,” she said. “China must change.”

It must adopt firms that leverage on technology, for these will help increase efficiency and sometimes replace labour, she added.

But while there is no shortage of money out there, with billions of dollars being poured into thousands of tech start-ups each year, just as many are going belly-up for shortage of funds or failure to commercialise their products.

This is because investors and consumers are becoming more discerning, and it is no longer enough for entrepreneurial hopefuls to just go and copy someone else’s idea and hope to thrive, investors and entrepreneurs told The Straits Times.

“These firms need to innovate to compete,” said Ms Lee. And innovation can be in terms of the business model, product or technology.

Some venture capitalists, such as Beijing-based James Tan, find Chinese tech firms to be very good at localising new ideas from Silicon Valley and achieving superior results on the mainland.

Still, Mr Peter Fuhrman, the chairman of China First Capital, a Shenzhen-based investment bank and advisory firm, pointed out that while this strategy has helped some of the home-grown tech giants to grow, it is not sustainable.

Successful tech players like Baidu, Alibaba and Tencent benefited greatly from an intellectual property and legal regime that allowed them to copy American business models and intellectual property without punishment, he said.

China’s market is also closed to foreign competitors, so that domestic firms can grow and thrive within a walled garden free from outside competition, he added.

However, he noted, it is harder now for China to shield its domestic firms from competition than in the late 1990s, when the tech giants got started, as China has since become a World Trade Organisation member.

“Walled gardens are basically illegal under WTO,” he said.

Another problem that could make it hard for China to grow the tech sector is the unique and “occasionally dysfunctional” capital market and initial public offering (IPO) regime, he said.

“This has now made it between difficult and impossible for Chinese tech companies to IPO within China,” he said.

Despite the problems, the push towards innovation and entrepreneurship looks set to continue, with more than 1,600 high-tech incubators nurturing start-ups across the nation.

Ms Mao Donghui, the executive director of Tsinghua x-lab, a university-based education platform for start-ups, said China is just beginning to wake up to the need for innovation. For start-ups to succeed, however, being innovative is not good enough – young people also need to know how to do business. For them to have the right combination of innovation and entrepreneurship would “require years of effort, right methods and experience”, said Ms Mao.

“It’s not that easy to just shout about innovation and entrepreneurship for a year or two, and expect to see results blossom, and affect economic growth. There is still a long way to go,” she said.

http://www.straitstimes.com/asia/east-asia/investors-rush-to-fund-china-tech-start-ups

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Five China financial news articles in the South China Morning Post

June 13th, 2016 No comments

SCMP logo good

 

Please click on headline to read article. Each includes quoted comments based on interviews with CFC.

 

Xinan

 

 

CSRC

 

 

Mergers

 

PE

 

Shunfenf

 

Why Taiwan Is Far Ahead of Mainland China in High-Tech — Financial Times commentary

June 8th, 2016 No comments

FT logo

Largan

Every country is touchy about some topics, especially when raised by foreigner. Living in China for almost seven years now, and having been a student of the place for the last forty, I thought I knew the hot buttons not to press. Apparently not.

The topic at hand: high-tech innovation in the PRC and why it seems to lag so far behind that of neighboring Taiwan. A recent issue of one of China’s leading business publications, Caijing Magazine, published a Chinese-language article I wrote together with China First Capital’s COO, Dr. Yansong Wang, about Taiwan’s high-flying optical lens company Largan Precision.

Soon after the magazine was published, it began circulating rather widely. Howls of national outrage began to reach me almost immediately. Mainly we were accused of not understanding the topic and having ignored China’s many tech companies that are at least the equal, if not superior, to Largan.

I didn’t think the article would be all that contentious, at least not the facts. Largan last year had revenues in excess of $1 billion and net profit margins above 40%, more than double those of its main customer, Apple, no slouch at making money. China has many companies which supply components to Apple, either directly or as a subcontractor. None of these PRC companies can approach the scale and profitability of Largan. In fact, there are few whose net margins are higher than 10%, or one-quarter Largan’s. Case in point: Huawei, widely praised within China as the country’s most successful technology company, has net margins of 9.5%.

Taiwan inaugurated its new president last month, Tsai Ing-wen, who represents the pro-Taiwan independence party. Few in the PRC seem to be in a mood to hear anything good about Taiwan. In one Wechat forum for senior executives, the language turned sharp. “China has many such companies, you as a foreigner just don’t know about them.” Or, “Largan is only successful because like Taiwan itself, it is protected by the American government” and “Apple buys from Largan because it wants to hold back China’s development”.

Not a single comment I’ve seen focused on perhaps more obvious reasons China’s tech ambitions are proving so hard to realize: a weak system of patent protection, widespread online censoring and restrictions on free flow of information, a venture capital industry which, though now large, has an aversion to backing new directions in R&D.  In Taiwan, none of this is true.

Largan is doing so well because the optical-quality plastic lenses it makes for mobile phone cameras are unrivalled in their price and performance. Any higher-end mobile phone, be it an iPhone or an Android phone selling for above $400, relies on Largan lenses.

Many companies in the PRC have tried to get into this business. So far none have succeeded. Largan, of course, wants to keep it that way. It has factories in China, but key parts of Largan’s valuable, confidential manufacturing processes take place in Taiwan. High precision, high megapixel plastic camera lenses are basically impossible to reverse-engineer. You can’t simply buy a machine, feed in some plastic pellets and out comes a perfect, spherical, lightweight 16-megapixel lens. Largan has been in the plastic lens business for almost twenty years. Today’s success is the product of many long years of fruitless experimentation and struggle. Largan had to wait a long time for the market demand to arrive. Great companies, ones with high margins and unique products, generally emerge in this way.

We wrote the article in part because Largan is not widely-known in China. It should be. The PRC is, as most people know, engaged in a massive, well-publicized multi-pronged effort to stimulate high-tech innovation and upgrade the country’s manufacturing base. A huge rhetorical push from China’s central government leadership is backed up with tens of billions of dollars in annual state subsidies. Largan is a good example close to home of what China stands to gain if it is able to succeed in this effort. It’s not only about fat profits and high-paying jobs. Largan is also helping to create a lager network of suppliers, customers and business opportunities outside mobile phones. High precision low-cost and lightweight lenses are also finding their way into more and more IOT devices. There are also, of course, potential military applications.

So why is it, the article asks but doesn’t answer, the PRC does not have companies like Largan? Is it perhaps too early? From the comments I’ve seen, that is one main explanation. Give China another few years, some argued, and it will certainly have dozens of companies every bit as dominant globally and profitable as Largan. After all, both are populated by Chinese, but the PRC has 1.35 billion of them compared to 23 million on Taiwan.

A related strand, linked even more directly to notions of national destiny and pride: China has 5,000 years of glorious history during which it created such technology breakthroughs as paper, gunpowder, porcelain and the pump. New products now being developed in China that will achieve breakthroughs of similar world-altering amplitude.

Absent from all the comments is any mention of fundamental factors that almost certainly inhibit innovation in China. Start with the most basic of all: intellectual property protection, and the serious lack thereof in China. While things have improved a bit of late, it is still far too easy to copycat ideas and products and get away with it. There are specialist patent courts now to enforce China’s domestic patent regime. But, the whole system is still weakly administered. Chinese courts are not fully independent of political influence. And anyway, even if one does win a patent case and get a judgment against a Chinese infringer, it’s usually all but impossible to collect on any monetary compensation or prevent the loser from starting up again under another name in a different province.

Another troubling component of China’s patent system: it awards so-called “use patents” along with “invention patents”. This allows for a high degree of mischief. A company can seek patent protection for putting someone else’s technology to a different use, or making it in a different way.

It’s axiomatic that countries without a reliable way to protect valuable inventions and proprietary technology will always end up with less of both. Compounding the problem in China, non-compete and non-disclosure agreements are usually unenforceable. Employees and subcontractors pilfer confidential information and start up in business with impunity.

Why else is China, at least for now, starved of domestic companies with globally-important technology? Information of all kinds does not flow freely, thanks to state control over the internet. A lot of the coolest new ideas in business these days are first showcased on Youtube, Twitter, Instagram, Snapchat. All of these, of course, are blocked by the Great Firewall of China, along with all kinds of traditional business media. Closed societies have never been good at developing cutting edge technologies.

There’s certainly a lot of brilliant software and data-packaging engineering involved in maintaining the Great Firewall. Problem is, there’s no real paying market for online state surveillance tools outside China. All this indigenous R&D and manpower, if viewed purely on commercial terms, is wasted.

The venture capital industry in China, though statistically the second-largest in the world, has shunned investments in early-stage and experimental R&D. Instead, VCs pour money into so-called “C2C” businesses. These “Copied To China” companies look for an established or emerging business model elsewhere, usually in the US, then create a local Chinese version, safe in the knowledge the foreign innovator will probably never be able to shut-down this “China only” version. It’s how China’s three most successful tech companies – Alibaba, Tencent and Baidu – got their start. They’ve moved on since then, but “C2C” remains the most common strategy for getting into business and getting funded as a tech company in China.

Another factor unbroached in any of the comments and criticisms I read about the Largan article: universities in China, especially the best ones, are extremely difficult to get into. But, their professors do little important breakthrough research. Professorial rank is determined by seniority and connections, less so by academic caliber. Also, Chinese universities don’t offer, as American ones do, an attractive fee-sharing system for professors who do come up with something new that could be licensed.

Tech companies outside China finance innovation and growth by going public. Largan did so in Taiwan, very early on in 2002, when the company was a fraction of its current size. Tech IPOs of this kind are all but impossible in China. IPOs are tightly managed by government regulators. Companies without three years of past profits will never even be admitted to the now years-long queue of companies waiting to go public.

Taiwan is, at its closest point, only a little more than a mile from the Chinese mainland. But, the two are planets apart in nurturing and rewarding high-margin innovation. Taiwan is strong in the fundamental areas where the PRC is weak. While Largan may now be the best performing Taiwanese high-tech company, there are many others that similarly can run circles around PRC competitors. For all the recent non-stop talk in the PRC about building an innovation-led economy, one hears infrequently about Taiwan’s technological successes, and even less about ways the PRC might learn from Taiwan.

That said, I did get a lot of queries about how PRC nationals could buy Largan shares. Since the article appeared, Largan’s shares shot up 10%, while the overall Taiwan market barely budged.

Our Largan article clearly touched a raw nerve, at least for some. If it is to succeed in transforming itself into a technology powerhouse, one innovation required in China may be a willingness to look more closely and assess more honestly why high-tech does so much better in Taiwan.

 

(An English-language version of the Largan article can be read by clicking here. )

(财经杂志 Caijing Magazine’s Chinese-language article can be read by clicking here.)

 

http://blogs.ft.com/beyond-brics/2016/06/07/why-taiwan-is-far-ahead-of-mainland-china-in-high-tech/

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China to fine-tune back-door listing policies for US-listed companies — South China Morning Post

May 11th, 2016 No comments

 

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China reverse mergers

Mainland China’s securities regulator will fine-tune policies related to back-door listing (reverse merger)attempts by US-listed Chinese companies, industry insiders say, but it is unlikely to ban them or impose other rigid restrictions.

“It is clear that the regulator does not like the recent speculation on the A-share markets triggered by the relisting trend and will do something to curb such conduct, but it seems impossible they would shut good-quality companies out of the domestic market,” Wang Yansong, a senior investment banker based in Shenzhen, said.

The China Securities Regulatory Commission (CSRC) was considering capping valuation multiples for companies seeking relisting on the A-share market after delisting from the US market, Bloomberg reported on Tuesday. Another option being discussed was introducing a quota to limit the number of reverse mergers each year from companies formerly listed on a foreign bourse.

To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals
Wang Yansong.

However, Wang said the CSRC was more likely to strengthen verification of back-door listing deals on a case-by-case basis.

“To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals, and won’t allow poor-quality companies to seek premiums through this process,” she said.

US-listed mainland companies have been flocking to relist on the A-share market since early last year, when the domestic market started a bull run, in order to shed depressed valuations in American markets.

The valuations of relisted companies have boomed, and that has triggered a surge in speculation on possible shell companies – poorly performing firms listed on the Shanghai or Shenzhen bourses. In a process called a reverse takeover or back-door listing, a shell can buy a bigger, privately held company through a share exchange that gives the private company’s shareholders control of the merged entity.

The biggest such deal was done by digital advertising company Focus Media. Its valuation jumped more than eightfold to US$7.2 billion after it delisted from America’s Nasdaq in 2013 and relisted in Shenzhen in December last year, with private equity funds involved in the deal reaping lucrative returns.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm, said the trend of delisting and relisting was “one of the biggest wealth transfers ever from China to the US”.

“The money spent by Chinese investors to privatise Chinese companies in New York ended up lining the pockets of rich institutional investors and arbitrageurs in the US,” he said.

However, a tightening or freeze on approval of such deals would threaten not only US-listed Chinese companies in the process of buyouts and shell companies, but also the buyout capital sunk into delistings and relistings.

“The more than US$80 billion of capital spent in the ‘delist-relist’ deals is perhaps the biggest unhedged bet made in recent private equity history … if, as seems true, the route to exit via back-door listing may be bolted shut, this investment strategy could turn into one of the bigger losers of recent times,” he said.

On Friday, CSRC spokesman Zhang Xiaojun sidestepped a question about a rumoured ban on reverse takeover deals by US-listed Chinese companies in the A-share market, saying it had noticed the great price difference in the domestic and the US markets, and the speculation on shell companies, and was studying their influences.

http://www.scmp.com/business/markets/article/1943386/china-fine-tune-back-door-listing-policies-us-listed-companies

For article on a related topic published in “The Deal”, please click here

 

Leapfrogging the IPO gridlock: Chinese companies get a taste for reverse takeovers — Reuters

May 6th, 2016 No comments

Reuters

Leapfrogging the IPO gridlock: Chinese companies get a taste for reverse takeovers

Qianhai investors fret over soaring property prices — China Daily

May 4th, 2016 No comments

 China Daily logo

Qianhai investors fret over soaring property prices

By Zhou Mo

Qianhai

Shenzhen – Hong Kong and foreign enterprises operating in the Qianhai special economic zone have expressed concern over Shenzhen’s high property prices and entrepreneurs’ ability to integrate with the mainland market.

But, they acknowledge that Qianhai’s preferential policies and open environment have made the zone an ideal place for businesses from Hong Kong and abroad to tap into the mainland market.

“From the aspect of government administration and environment, Shenzhen, I believe, is the best place to set up business in the country, and Qianhai is the best area in Shenzhen,” said Peter Fuhrman, chairman and chief executive officer of China First Capital, an investment bank.

“However, from the aspect of cost, it’s not the best. Soaring property prices in the city have increased costs for businesses, and there needs to be a solution,” the US entrepreneur said.

Wednesday marked the first anniversary of Shenzhen’s Qianhai and Shekou zones coming into operation as part of the China (Guangdong) Pilot Free Trade Zone, which also includes Zhuhai’s Hengqin and Guangzhou’s Nansha districts.

As of April 15, more than 91,000 enterprises had been registered in the zone, with registered capital amounting to 4 trillion yuan ($616 billion). Among them, over 3,100 were Hong Kong-funded enterprises, which contributed nearly one-third of the zone’s tax revenue.

“Qianhai will continue to focus on cross-border cooperation between Shenzhen and Hong Kong, and strive to create a platform to support Hong Kong’s stability and prosperity,” Tian Fu, director of the administrative committee of Qianhai and Shekou, said at a ceremony marking the first anniversary on Wednesday.

Innovation and entrepreneurship are among the key areas of cross-border cooperation. To attract Hong Kong entrepreneurs to set up business across the border, the Qianhai Shenzhen-Hong Kong Youth Innovation and Entrepreneur Hub (E Hub) was launched, providing tax incentives, funding opportunities and free accommodation to Hong Kong entrepreneurs. As a result, more and more startups from the SAR are setting up offices in the E Hub.

“The opportunity cost in Hong Kong for entrepreneurs is relatively high, with high rents and labor costs, and the Hong Kong market is small,” said Amy Fung Dun-mi, deputy executive director of the Hong Kong Federation of Youth Groups. “Therefore, it’s wise for them to tap into the mainland market.”

Many of the companies have been doing well, Fung said, while noting that some have not made much progress so far.

Fung said when Hong Kong entrepreneurs start operating on the mainland, it’s necessary that mentors are provided to help them, as environment, laws and policies between Shenzhen and Hong Kong are different.

She also urged the authorities to provide more support to help Hong Kong startups find investors.

http://www.chinadailyasia.com/business/2016-04/28/content_15424101.html

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Reworking a formula for economic success — China Daily Commentary

April 8th, 2016 No comments

 

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Reworking a formula for economic success

By PETER FUHRMAN (China Daily) Updated: 2016-04-08

Reworking a formula for economic success
An assembly line of a Daimler AG venture in Minhou, Fujian province.

My on-the-ground experience in China stretches back to the beginnings of the reform era in 1981. Yet I cannot recall a time when so much pessimism, especially in English-language media, has surrounded the Chinese economy. Yes, it is a time of large, perhaps unprecedented transition and challenge.

But the negative outlook is overdone, and starts from a false premise. China does not need to search for a new economic model to generate further prosperity. Instead, what is happening now is a return to a simple formula that has previously worked extraordinarily well: applying pressure on China’s State-owned enterprises to improve their efficiency and profitability, while also doing more to tap China’s most abundant and valuable “natural resource”-the entrepreneurial spirit of the Chinese people, the talent to start a company, provide new jobs and build a successful new business.

These two together provided the impetus for the economic growth since the 1990s. In the 1990s, SOEs accounted for perhaps as much as 90 percent of China’s total economic output. Today, the SOEs’ share has fallen to below 40 percent by most counts. Once the main engine of growth, SOEs are now more like an anchor. Profits across the SOEs have been sinking, while their debt has risen sharply.

Arresting that slide of SOEs is now vital. SOE reform has long been on the agenda of the Chinese government. But such a reform has become more urgent than ever, as well as more difficult. There are fewer SOEs today than in 1991 when serious SOE reform was first undertaken. Among those that remain, many are now extremely big and rank among the biggest companies in the world. The restructuring of any such large company is always difficult.

China, however, has taken some key first steps in that direction. The Chinese government has divided SOEs into those that will operate entirely based on market principles and those that perform a social function. It is downsizing the coal and steel industries, two of the largest red-ink sectors. Senior managers of some large SOEs have been dismissed or are under investigation for corruption, and experiments linking SOEs’ salaries more directly with profitability are underway.

Less noticed, but in my opinion, as important is a strong push now at some SOEs and SOE-affiliated companies to become not better but among the best in the world at what they do. Tsinghua Unigroup in semiconductors, China National Nuclear Corporation and China General Nuclear Power in building and operating nuclear power plants, and CITIC Group in eldercare are seeking global glory. They are trying to sprint while most other SOEs are limping.

Luckily for China, the overall situation in the entrepreneurial sector is far rosier. All it needs is a more level playing field. Important steps to further free up the private sector are now underway-taxes are being cut, banks pushed to lend more, and markets long closed to protect SOE monopolies are being pried open. Healthcare is a good example in this regard.

All these moves are part of what the government calls its new “supply side” policy. The aim is to demolish barriers to competition and efficiency. Chinese entrepreneurs have shown time and again they have world-class aptitude to spot and seize opportunities. They are leading the charge now into China’s underdeveloped service sector. This, more than manufacturing or exports, is where new jobs, profits and growth will come from.

Opportunities also await smart entrepreneurs in less efficient industries like agriculture, in getting food products to market quickly, cheaply and safely. In cities, traditional retail has been hit hard by online shopping. Struggling shopping malls are becoming giant laboratories where entrepreneurs are incubating new ideas on how Chinese consumers will shop, play, eat and be entertained.

China’s economy is now 30 times larger than what it was in 1991, and far more complex. The private sector 25 years ago was then truly in its infancy. But, there is still huge scope today for China to gain from its original policy prescription: prodding SOEs to get in line for reform while letting entrepreneurs meet the needs of Chinese consumers.

The author is chairman and CEO of China First Capital.

 

http://www.chinadaily.com.cn/opinion/2016-04/08/content_24364851.htm

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How Renminbi funds took over Chinese private equity (Part 2) — SuperReturn Commentary

April 4th, 2016 1 comment

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How Renminbi funds took over Chinese private equity

(Part 2)

 
Large and small ships traverse the Huangpu River 24 hours a day, 7 days a week, and 365 days a year.

Part two of a series. Read part one.

Gresham’s Law, as many of us were taught a while back, stipulates that bad money drives out good. There’s something analogous at work in China’s private equity and venture capital industry. Only here it’s not a debased currency that’s dominating transactions. Instead, it’s Renminbi private equity (PE) firms. Flush with cash and often insensitive to valuation and without any clear imperative to make money for their investors, they are changing the PE industry in China beyond recognition and making life miserable for many dollar-based PE and venture capital (VC) firms.

Outbid, outspent and outhustled

From a tiny speck on the PE horizon five years ago, Reminbi (RMB) funds have quickly grown into a hulking presence in China. In many ways, they now run the show, eclipsing global dollar funds in every meaningful category – number of active funds, deals closed and capital raised. RMB funds have proliferated irrespective of the fact there have so far been few successful exits with cash distributions.

The RMB fund industry works by a logic all its own. Valuations are often double, triple or even higher than those offered by dollar funds. Term sheets come in faster, with fewer of the investor preferences dollar funds insist on. Due diligence can often seem perfunctory.  Post-deal monitoring? Often lax, by global standards. From the perspective of many Chinese company owners, dollar PE firms look stingy, slow and troublesome.

The RMB fund industry’s greatest success so far was not the IPO of a portfolio company, but of one of the larger RMB general partners, Jiuding Capital. It listed its shares in 2015 on a largely-unregulated over-the-counter market called The New Third Board. For a time earlier this year, Jiuding had a market cap on par with Blackstone, although its assets under management, profits, and successful deal record are a fraction of the American firm’s.

The main investment thesis of RMB funds has shifted in recent years. Originally, it was to invest in traditional manufacturing companies just ahead of their China IPO. The emphasis has now shifted towards investing in earlier-stage Chinese technology companies. This is in line with China’s central government policy to foster more domestic innovation as a way to sustain long-term GDP growth.

The Shanghai government, which through different agencies and localities has become a major sponsor of new funds, has recently announced a policy to rebate a percentage of failed investments made by RMB funds in Shanghai-based tech companies. Moral hazard isn’t, evidently, as high on their list of priorities as taking some of the risk out of risk-capital investing in start-ups.

Dollar funds, in the main, have mainly been observing all this with sullen expressions. Making matters worse, they are often sitting on portfolios of unexited deals dating back five years or more. The US and Hong Kong stock markets have mainly lost their taste for PE-backed Chinese companies. While RMB funds seem to draw from a bottomless well of available capital, for most dollar funds, raising new money for China investing has never been more difficult.

RMB funds seldom explain themselves, seldom appear at industry forums like SuperReturn. One reason: few of the senior people speak English. Another: they have no interest or need to raise money from global limited partners. They have no real pretensions to expand outside China. They are adapted only and perhaps ideally to their native environment. Dollar funds have come to look a bit like dinosaurs after the asteroid strike.

Can dollar-denominated firms strike back?

Can dollar funds find a way to regain their central role in Chinese alternative investing? It won’t be easy. Start with the fact the dollar funds are all generally the slow movers in a big pack chasing the same sort of deals as their RMB brethren. At the moment, that means companies engaged in online shopping, games, healthcare and mobile services.

A wiser and differentiated approach would probably be to look for opportunities elsewhere. There are plenty of possibilities, not only in traditional manufacturing industry, but in control deals and roll-ups. So far, with few exceptions, there’s little sign of differentiation taking place. Read the fund-raising pitch for dollar and RMB funds and, apart from the difference in language, the two are eerily similar. They sport the same statistics on internet, mobile, online shopping penetration: the same plan to pluck future winners from a crop of look-alike money-losing start-ups.

There is one investment thesis the dollar PE funds have pretty much all to themselves. It’s so-called “delist-relist” deals, where US-quoted Chinese companies are acquired by a PE fund together with the company’s own management, delisted from the US market with the plan to one day IPO on China’s domestic stock exchange. There have been a few successes, such as the relisting last year of Focus Media, a deal partly financed by Carlyle. But, there are at least another forty such deals with over $20bn in equity and debt sunk into them waiting for their chance to relist. These plans suffered a rather sizeable setback recently when the Chinese central government abruptly shelved plans to open a new “strategic stock market” that was meant to be specially suited to these returnee companies. The choice is now between prolonged limbo, or buying a Chinese-listed shell to reverse into, a highly expensive endeavor that sucks out a lot of the profit PE firms hoped to make.

Outspent, outbid and outhustled by the RMB funds, dollar PE funds are on the defensive, struggling just to stay relevant in a market they once dominated. Some are trying to go with the flow and raise RMB funds of their own. Most others are simply waiting and hoping for RMB funds to implode.

So much has lately gone so wrong for many dollar PE and VC in China. Complicating things still further, China’s economy has turned sour of late. But, there’s still a game worth playing. Globally, most institutional investors are under-allocated to China.  A new approach and some new strategies at dollar funds are overdue.

Peter Fuhrman moderates our SuperReturn China 2016 Big Debate: ‘How Do You Best Manage Your Exposure To China?’. Discussants include:

  • John Lin, Managing Partner, NDE Capital (GP)
  • Xisheng Zhang, Founding Partner & President, Hua Capital (GP)
  • Bo Liu, Chief Investment Officer, Wanda Investment (LP)
The Big Debate takes place on Tuesday 19 April 2016 at 11:55 – 12:25 at SuperReturn China in Beijing. Can’t make it? Follow the action on Twitter.

New Year gambling hints at Chinese entrepreneurial vigour — The Financial Times

February 23rd, 2016 No comments

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FT beyondbrics

With about every major leading economic indicator in a tailspin, it’s easy, even obvious, to be bearish about China. But, one sign of economic activity could hardly seem more robust: the crowds and cash at gambling tables during this year’s Chinese New Year.

The two-week long lunar New Year celebration finally drew to a close on Monday with the Lantern Festival. Here in Shenzhen, China’s richest city per capita, no sooner do the shops all shut down for the long break than the gambling tables spill out onto the street, like the cork flying out of a bottle.

Gambling, especially in public places with large sums being wagered, is illegal everywhere in China. All the same, the New Year is ready-made for gamblers and street-corner croupiers to gather. For one thing, most police and urban street patrols are also away from their jobs with family.

Along with over-eating and giving cash-stuffed red envelopes, gambling is the other main popular indulgence during the New Year. Most of it happens behind closed doors with families gathered around the mahjong and card table. But parts of Shenzhen soon take on the appearance of an al fresco Macau (see photo).

 

 

 

 

 

 

 

 

 

 

This year, from what I could see, the number of punters and sums being wagered was far higher than years past. This matters not only as a statement of consumer optimism here but also as affirmation of the love of risk-taking that helps make China such a hotbed of entrepreneurial activity.

The two forces operating together – not only at street corner casinos — are perhaps the best reason to be optimistic that China’s economy may yet avoid a “hard landing” and continue to thrive.

In my neighborhood, the favorite game on the street is a form of craps where people bet on which of six auspicious animals and lucky symbols will turn up. Hundreds of renminbi change hands with each roll. No small bets allowed. The gambling goes on from morning until late at night.

It’s a game that requires no skill and one that also gives the house a huge advantage, since winning bets only make four times the sum wagered. This puts it in a somewhat similar league with punto banco baccarat, the casino game Chinese seem to like the most. It’s also game of pure chance, where the house has a built-in edge.

In China, gamblers’ capital flows to games with unfair odds, where dumb luck counts for more than smarts. In this there is cogent parallel with the investment culture in China. China is simply awash in risk-loving risk capital.

Street-side gambling is popular during the New Year break in part because the other more organised mainstream forms of taking a punt are shut down. Top of the list, of course, is the Chinese domestic stock market. It’s rightly called the world’s largest gambling den. Shares bob up and down in unison, prices decoupled from underlying economic factors, a company’s own prospects or comparable valuations elsewhere.

The simple reason is that almost all shares are owned by individual traders. Fed on rumors and goaded by state-owned brokerage houses, they seem to give no more thought to which shares to buy than my neighbors do before betting Rmb200 on which dice will land on the lucky crab.

The housing market, too, traces a similar erratic arc, driven far more by short-term speculation than the need to put a roof over one’s head. Billions pour in, bidding up local housing prices in many Chinese cities to a per-square-foot level higher than just about anywhere in the West except London, Paris, New York and San Francisco. Eventually prices do begin to moderate or even fall, as happened in most smaller cities this past twelve months.

The other big pool of risk capital in China goes into direct investment in entrepreneurial ventures of all sizes and calibers. Nowhere in the world is it easier to raise money to start or grow a business than China. In part, because Chinese have a marked preference for being their own boss, so the number of new companies started each year is high. The other big factor, call it the demand side, is that there is both a lot of money available and a great enthusiasm for investing in the new, the untried, the risky.

Before coming here, I used to work in the venture capital industry in California. VCs there are occasionally accused of turning a blind eye toward risk. Compared to venture investing in China, however, even the most starry-eyed venture investor in Silicon Valley looks like a Swiss money manager.

Just about any idea here seems to attract funding, a lot of it institutional. China now almost certainly has more venture firms than the rest of the world combined. No one can keep proper count. Along with all the big global names like Sequoia and Kleiner Perkins, there are thousands of other China-only venture firms operating, along with at least as many angel groups. In addition, just about every Chinese town, city and province, along with most listed companies, have their own venture funds.

I marvel at the ease with which early-stage businesses get funded, the valuations they command and the less than diligent due diligence that takes sometimes place before money moves. Of course, a few of these venture-backed companies hit the jackpot.

Alibaba or Tencent are two that come to mind. But, initial public offering (IPO) exits for Chinese startups remain rare, and so taken as a whole, venture investing returns in China have proved meager. But, activity never seems to wane. Fad follows fad. From group shopping, to what’s known in China as “O2O” (offline-to-online) thousands of companies get started, funded and then often within less than 18 months, go pffft.

With the New Year celebrations winding down, the outdoor gambling tables in my neighborhood are being put away for another year. Work schedules are returning to normal. For all the headwinds China’s economy now faces, Chinese household savings are still apparently growing faster than GDP. This means Chinese will likely go on year-after-year amassing more money to invest, to gamble or to speculate.

 

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http://blogs.ft.com/beyond-brics/2016/02/22/new-year-gambling-hints-at-chinese-entrepreneurial-vigour/

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Why Taiwan has a Largan and China doesn’t — Nikkei Asian Review

February 4th, 2016 No comments

Nikkei 1

 

iphone6

 

Why Taiwan has a Largan and China doesn’t

PSF

No Asian technology company is currently more successful, dominant and more deeply engrained in the daily lives of a billion-plus people worldwide than Largan Precision. While you may not know the name, odds are you carry Largan technology around with you every day.

Largan makes the tiny plastic camera lenses for the high-megapixel cameras built into the iPhone and most higher-end Android devices. Largan enjoys a near-monopoly and is probably the only company in the world supplying an important high-margin component to both Apple and its Android rivals. That means even if Apple’s growth begins to cool, Largan won’t suffer as acutely as other key Apple component suppliers like Silicon Valley favorites Cirrus Logic and InvenSense. Apple may now be more dependent on Largan than Largan is on Apple.

Not that Largan is eager for the world-at-large to know. Though publicly-traded on the Taiwan Stock Exchange, the company is extremely reticent about sharing much information on its robust financial health and its current hammerlock hold on Apple. Largan habitually issues rather gloomy-sounding forecasts, as it did earlier this month, suggesting its growth rate may be slowing. Though its share price has nearly doubled in the last two years, it still trades at an anemic p/e multiple of under 10 times projected 2016 net income.

Smartphone sales are beginning to plateau Also casting a potential shadow, Apple is said to be keen to find an alternative camera lens supplier. The Cupertino company loathes having single-source suppliers like Largan. But, so far it’s proving all but impossible for Apple to find another supplier to match Largan’s price, volume and quality. Patents, Largan has them in abundance. But, its most valuable innovations, the ones Apple and its other customers pay good money for,  are mainly unpublished: the sophisticated manufacturing know-how needed to produce in massive quantities at low-cost tiny specs of curved plastic at optical quality.

Fortunes rise and fall quickly in the mobile phone industry. If more proof were needed, just look at Xiaomi, which went from the world’s highest valued to perhaps most overvalued startup in less than a year. Largan, meanwhile, quarter after quarter, remains the envy of the entire Apple and Android manufacturing world.

Cameras — and the quality of photos they take — have never been a more important selling point for mobile handset makers. All the key trends — higher resolution lenses with larger apertures, high-quality cameras front and back, optical zoom and image stabilization — play directly to Largan’s proprietary strengths and know-how.  The result, Largan also enjoys about the highest growth rate and market share along with net profit margins among all key mobile component manufacturers.

Despite the slowdown in the growth of mobile phone sales, Largan’s 2015 revenues rose by over 20% to reach $1.7bn, while net income surpassed $700mn. Largan’s +40% net profit margin are double Apple’s.

Few are the public companies anywhere that throw up numbers like Largan’s:

Largan is an example of a company that waited a long time for its moment in the sun. It was started 29 years ago and is still run by its two original founders, Tony Chen and Scott Lin. Both are now dollar billionaires and well past Taiwan’s official retirement age of 65.

I’ve never met the founders, or anyone else from Largan. I’ve learned about the company from the CEOs of some other large Apple and Android suppliers we work with. They uniformly sing Largan’s praises. “Though I try, I can’t find a single weak point except maybe that the founders should probably be retired and working on their golf game” muses one whose Hong Kong-listed company has been trying without success to get into the business selling plastic camera lens to Apple.

If rumors are correct, the next version of the larger iPhone will include dual cameras, front and back, each with much higher megapixel count than the current iPhone6. If so, and Largan as is likely remains the principal supplier, Largan’s revenues and profits from each iPhone sold will increase. Largan already makes similar lenses in bulk for Android brands.

For many years, the company was a small, niche manufacturer, one of dozens in the optics industry clustered around the city of Taichung. Largan’s focus then and now was producing high-quality lenses from plastic rather than glass. Early on plastic lenses seemed more like a novelty, too low in quality to ever seriously compete with the fine glass optical lenses made in Japan for the country’s major camera brands like Nikon, Canon and Minolta.

Largan’s plastic lenses were originally consigned mainly for use inside desktop scanners and projectors. Then the smartphone came along. A decade ago, only half the smartphones sold each year had a built-in camera. Now, it’s nearly 100%. Megapixel count has risen from two to sixteen and sometimes higher. Largan has been at the forefront throughout, but especially over the last five years as specs get higher and customers more demanding. A handset camera needs to take great pictures, but do so without adding much weight, sucking too much battery life or hogging too much space. Glass simply can’t cut it.

Among plastic lens manufacturers, no one else can currently match Largan’s know-how, precision and manufacturing skill. The camera in your mobile phone is a remarkable bit of gear. A typical high-end smartphone camera now has multiple aspherical Largan lenses with different dispersion and refractive properties, stacked about four millimeters high inside a plastic mount. To achieve perfect focus, the lenses need to be perfectly aligned, moveable, have as wide an aperture as possible and optical image stabilization.

Largan makes only lenses. The complete camera module (see photo below of the module from the iPhone) is assembled by other manufacturers, a task that still requires some hand labor and offers tiny margins of 5% or less.

Hon Hai, more commonly known as Foxconn, is one of the companies doing the low-paid module assembly work. Foxconn and Largan are both key Apple suppliers, but sit at opposite ends of the margin spectrum.

Two other things they share in common: both are Taiwanese companies with a large manufacturing presence in China. This underscores an important point about the relative level of technology development in Taiwan and the PRC. Taiwan companies remain light-years ahead in the majority of cases.

Looking just at the Apple ecosystem, while most components as well as finished products are manufactured in China, mainland Chinese companies barely earn a dime from all this. There is no more unbalanced balance-of-trade than the iPhone’s manufacturing and sales in China. Chinese bought around 70 million iPhones last year, with a retail value of over $70bn. But, only a fraction of that stays in China, mainly in the form of sales tax collected by the government from sales in official retail channels and the wages paid to assembly staff at hundreds of factories producing for Apple. The picture isn’t very different with Android phones. What profits there are end up in the hands of high-value non-PRC software and component suppliers, including Largan.

Despite the PRC’s generous subsidies to technology companies and a massive government push to foster indigenous innovation, China’s domestic technology manufacturers remain overwhelmingly stuck producing low-margin commoditized products without any globally significant high-margin IP. True, the PRC got a late start compared to Taiwan. But, there are some other often overlooked systemic factors at work here.

Start with the fact intellectual property remains weakly protected. Mainland Chinese companies have less incentive to do as Largan did and plow years of effort and investment into a new technology with an uncertain path to market.

Seeking risk capital is most often a hopeless quest. The Shanghai and Shenzhen stock exchanges do not allow smaller companies with promising technology and zero profits to go public. China’s domestic venture capital industry most always shuns start-ups working on truly innovative high-tech products, preferring knock-offs of successful US online business models where revenues, if not profits, can be generated more quickly. Longer-term bank lending is all but non-existent.

Another factor that I believe inhibits innovation in China – the country relied on technology transfer, on forcing companies from the developed world to turn over to Chinese joint venture partners some proprietary technology in return for access to the Chinese market. Why innovate at home when foreign companies can be made to hand over trade secrets, albeit outdated ones, for free? This has stunted the growth of a strong foundation of homegrown innovation in China.

China took on low-margin work spurned by earlier generations of Japanese, Korean and Taiwanese manufacturers. But, Chinese companies have so far mainly failed to build something more substantial on top of this by adding their own proprietary improvements that can command higher prices. Margins, always threadbare, are instead vaporizing across the domestic manufacturing sector due to rising wages, benefits, environmental compliance and energy costs as well as taxes.

Then look at Largan. Its margins, despite weak overall mobile phone growth, are on track to actually increase this year above already stellar levels. As good as the camera on your mobile is, there is enormous scope for the hardware to get better, smaller, lighter, faster, flatter. It’s hard to envisage anyone else pushing the process more propulsively and successfully than Largan.

 

Download our Chinese-language article on Largan as published in Caijing Magazine

As published in Nikkei Asian Review

Download PDF version.