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English-language proprietary research report on private equity and M&A in China, 2012-2013. Written by China First Capital, a leading specialist China-focused investment bank
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Private Equity in China 2012 - 2013
Positive Trends & Growing Challenges
INSIDE THIS REPORT:
Too Few Exits: Core Challenge for PE in China 2
From IPO to IRR: PE's Changing Game-plan 4
RMB Funds New Model 6
The OTCBB-Ization of HKSE 8
The CSRC Disciplines IPO Process 10
China's SOEs Transform 11
Xinjiang Rewrites China's Energy Policy 13
China's Huge Unknown Entrepreneur 15
Too Few Exits – The Core Here’s a way to understand the problem: there is
probably now over $50 billion in private equity
Challenge Facing Private capital invested in Chinese private companies, with
Equity in China another $50 billion at least in capital raised but not
yet committed. That is enough to finance
investment in around 6,500 Chinese companies,
since average investment size remains around
The amount of capital going into private equity in $15mn.
China continues to surge, with over $30 billion in
new capital raised in 2011. The number of private At the moment, only about 250 Chinese private
equity deals in China is also growing quickly. More companies go public each year domestically. The
money in, however, does not necessarily mean reason is that the Chinese securities regulator,
more money will come out through IPOs or other the CSRC, keeps tight control on the supply of new
exits. In fact, on the exit side of the ledger, there issues. Their goal is to keep the supply at a level
is no real growth, instead probably a slight decline, that will not impact overall stock market valuations.
as the number of domestic IPOs in China stays Getting CSRC approval for an IPO is becoming
constant, and offshore IPOs (most notably in Hong more and more like the camel passing through the
Kong and USA) is trending down. M&A activity, the eye of a needle. Hundreds of companies are
other main source of exit for PE investors, remains waiting for approval, and many hundreds more will
small in China. likely join the queue each year by submitting IPO
applications to the CSRC.
This poses the most important challenge to the
long-term prospects for the private equity industry Is it possible the CSRC could increase the number
in China. The more capital that floods in, the larger of IPOs of private companies? In theory, yes. But,
the backlog grows of deals waiting for exit. This there is no sign of that happening, especially with
imbalance is going to become a key fact of life, the stock markets now trading significantly below
and ultimately a big impediment, to the continued their all-time highs. The CSRC’s primary role is to
expansion of capital raised for investing in China. assure the stability of China’s capital markets, not
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to provide a transparent and efficient mechanism drag down PE firms’ overall investment
for qualified firms to raise money from the stock performance.
market.
Until recently, the best-performing PE firms active
Coinciding now with the growing backlog of in China could achieve annual IRRs of over 50%.
companies waiting for domestic IPOs, offshore Such returns have made it easy for the top firms
stock markets are becoming less and less like CDH, SAIF, New Horizon, and Hony to raise
hospitable for Chinese companies. In Hong Kong, money. But, it may prove difficult for these firms
it’s generally only bigger Chinese companies, with to do as well with new money as they did with the
offshore shareholder structure and annual net old.
profits of at least USD$25 million, that are most
These good firms generally have the highest
welcome.
success rates in getting their deals approved for
In the US, most Chinese companies now have no domestic IPO. That will likely continue. But, with so
possibility to go public. There is little to no investor many more deals being done, both by these good
interest. As the Wall Street Journal aptly puts it, firms as well as the hundreds of other newly-
“Investors have lost billions of dollars over the last established Renminbi firms, the percentage of IPO
year on Chinese reverse mergers, after some of exits for even the best PE firms seems certain to
the companies were accused of accounting fraud decline.
and exaggerating the quality and size of their
The assumption is exits through M&A will increase
assets. Shares of other Chinese companies that
significantly. After all, this is now the main exit
went public in the United States through the
route for PE and VC deals done in the US and
conventional initial public stock offering process
Europe. But, there are significant obstacles to
have also been punished out of fear that the
taking the M&A exit route in China, from a
problem could be more widespread.”
shortage of domestic buyers with cash or shares to
Other minor stock markets still actively beckon use as currency, to regulatory issues, and above
Chinese companies to list there, including Korea, all the fact many of the best private companies in
Singapore, Australia. Their problem is very low IPO China are founded, run and majority-owned by a
price-earnings valuations, often in single digits, as single highly-talented entrepreneur. If he or she
low as one-tenth the level in China. As a result, sells out in M&A deal, the new owners will have a
IPOs in these markets are the choice for Chinese very hard time doing as well as the old owners did.
companies that truly have no other option. That So, even where there are willing sellers, the
creates a negative selection bias. Bad Chinese number of interested buyers in an M&A deal will
companies go where good companies dare not always be few.
tread.
Measured by new capital raised and investment
For the time being, LPs still seem willing to pour results achieved, China’s private equity industry
money into funds investing in China, ignoring or has grown a position of global leadership in less
downplaying the issue of how and when than a decade. There is still no shortage of great
investments made with their money will become companies eager for capital, and willing to sell
liquid. PE firms certainly are aware of this issue. shares at prices highly appealing to PE investors.
They structure their investment deals in China with But, unless something is done to increase
a put clause that lets them exit, in most cases, by significantly the number of PE exits every
selling their shares back to the company after a year, the PE industry in China must eventually
certain number of years, at a guaranteed annual contract. That will have very broad consequences
IRR, usually 15%-25%. That’s fine, but if, as not just for Chinese entrepreneurs eager for
seems likely, more and more Chinese investments expansion capital and liquidity for their shares, but
exit through this route, because the statistical also for hundreds of millions of Chinese, Americans
likelihood of an IPO continues to decline, it will and Europeans whose pension funds have money
now invested in Chinese PE. Their retirements will
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be a little less comfortable if, as seems likely, a the percentage of deals achieving a domestic IPO
diminishing number of the investments made in in China may not reach 10%. If so, overall returns
Chinese companies have a big IPO payday. for each PE firm, as well as the industry as a whole,
will fall rather dramatically from the high levels of
recent years.
The returns for most PE and VC firms across the
From IPO to IRR: The world tend toward bell curve distribution, with a
Changing Return Formula small number of highly successful deals more than
covering losses at the deals gone sour, and the
in Chinese Private Equity majority of deals achieving modest increases or
declines. In China, however, the successful deals
have tended to be both more numerous and more
Most investors would be delighted to make 15% profitable. This has provided most of the
to 20% per year, year after year. But, for many propulsive thrust for the high rates of return.
private equity firms active in China, that kind of
return would be cause for shame. The reason is The higher the rate of return, the easier it is to
that recent past returns from Chinese PE , and so raise new money. PE firms each year keep 1% to 2%
the expectations of LPs, is much higher, often of the money they raise every year as a
overall annual increases of 40%-60% a year, with management fee. It’s a kind of tithe paid by LPs.
successful individual deals increasing by 100% a PE firms also usually keep 20% of the net
year in value during a typical three to five year investment profits. But, this management fee is
holding period. risk-free, and usually is enough to fully pay for the
PE and VC firms salaries, offices, travel and other
But, it is quickly becoming much more challenging operating expenses, with anything left over split
to earn those +40% annual rates of return. My among the partners.
prediction is that profits from PE investing in China
will soon begin a rather steep downward slide. This So, high rates of investment return in the past
isn’t because there are fewer good Chinese ends up translating into lots of new money
companies to invest, or that valuations are rising unlinked to actual investment performance in the
sharply. Neither is true. It’s simply that a declining future. It’s a neat trick, and explains why the PE
percentage of PE deals done in China will achieve partners currently most actively out raising capital
those exceptionally high profits of 500%-800% or are mainly those investing in China. The more you
more over the life of an investment. raise now, the longer your guaranteed years of the
good life. In other words, even if overall
The reason is that fewer and fewer PE deals in investment results deteriorate in coming years, the
China will achieve exit through IPO. Those are the guaranteed income of PE firms will remain strong.
deals where the big money is made. There are no Most funds have a planned lifespan of seven to ten
precise numbers. But, my estimate would be that years. So, if you raise $1 billion in 2012, you will
in recent years, one in four PE investments made have perhaps $20mn a year in guaranteed
by the top 50 firms active in China managed to management fee income all the way through 2022.
have an IPO. Those are the deals with the outsized
rates of return that do so much to lift a PE firm’s The more new capital that’s raised for PE deals in
overall IRR. China, the more investment deals can get done.
The problem is, IPOs in China are basically a fixed
In the future, the rate of successful IPO exit may commodity, with about 250 private companies
fall by 30% or more for the good firms. For lesser going public a year. These domestic Chinese IPOs
PE firms, including many of the hundreds of are the common thread linking most of the highest
Renminbi firms set up over the last three years, return PE deals. The Chinese IPOs will continue,
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and most likely continue to provide some of the The direction of Chinese PE is moving from IPO to
highest profits available to PE firms anywhere. But, IRR. As this process unfolds, and PE returns in
with the number of IPOs static and overall PE China begin to trend downward, the PE investment
investment surging, the odds of a PE-backed process and valuations are likely to change, most
company in China getting the green light for IPO likely for the worse. IRR deals seldom make
will drop — rather precipitously if the current anyone happy—not the PE firms, their LPs or the
gusher of new money for PE deals in China persists. entrepreneur.
Meantime, the number of Chinese companies going Chinese PE still offers some of the best risk-
public outside China is dropping and will likely adjusted returns of any investment class. But, as
continue to. The US has all but barred the door to often happens, the outsized returns of recent years
Chinese companies, following a spate of stories in attracts a glut of new money, leading to an
2011 about fraudulent accounting and false eventual decline in overall profits. In investing, big
disclosure by Chinese companies quoted there. In success today often breeds mediocrity tomorrow.
Hong Kong, the only Chinese companies
generating investor enthusiasm at IPO are ones
with both significant size (profits of at least
USD$25mn) and an offshore legal corporate
structure. It used to be both simple and common
for Chinese companies to set up holding companies
outside China. The Chinese government has moved
aggressively to shut down that practice, beginning
in 2006. So, the number of private Chinese
companies with the legal structure permitting a
Hong Kong (or US, Singapore, Korean, Australian)
IPO will continue to shrink.
Add it up and the return numbers for PE firms
active in China begin to look much less rosy going
forward than they have in the past. More deals will
end in mandatory buybacks, rather than IPOs. This
is the escape mechanism written into just about
every PE investment contract. It allows the PE firm
to sell their shares back to the company if an IPO
doesn’t take place within a specified period of time,
typically three to five years. The PE gets its original
investment back, plus an annual rate of return
(“IRR”), usually 10% to 20%.
This way PE firms can’t get stuck in an illiquid
investment. The buybacks should become an
increasingly common exit route for PE deals in
China. But, they only work when the company can
come up with the cash to buy the PE shares back.
That will not always be certain, since pooling large
sums of money to pay off an old investor is hardly
the best use of corporate capital. Fighting it out in
court will likely be a fraught process for both sides.
5
Renminbi Funds Seek to meaning the GP keeps 20% of net profits earned
investing LPs’ money.
Rewrite the Rules of
Profitable Investing Of course, partnership structure doesn’t guarantee
GPs are going to do smart things with LPs’ money.
There’s lot of examples to the contrary. But, the
partnership structure does seem to work better for
Renminbi private equity funds are the world’s both sides than any other form of business
fastest-growing major pool of discretionary combination. GPs and LPs both know that the more
investment funds, with over $20 billion raised in the GP makes for himself, the more he makes for
2011. These Renminbi funds also play an investors.
increasingly vital role in allocating capital to
China’s best entrepreneurial companies. Despite Renminbi funds, in most all cases, are structured
their size and importance, these Renminbi funds like ordinary investment companies, or as
often have a structural defect that may limit their subsidiaries of larger state-owned financial holding
future success. companies. Instead of partners, they have large
management teams and board of directors. The
Most Renminbi funds are managed by people top people at Renminbi funds are picked as much
whose pay is only loosely linked, if at all, to their for their political connections, and ability to source
performance. They are structured, typically, much investment capital from government bureaus and
like a Chinese state-owned enterprise SOEs, as their investing acumen. They are wage
(“SOE”), with multiple managerial levels, slow and slaves, albeit well-paid ones by Chinese standards.
diffuse decision-making, rigid hierarchies and little But, their compensation might not even be 5% of
individual responsibility or accountability. The what a partner at a dollar-based private equity
resemblance to SOEs is not accidental. Renminbi firm can earn in a good year. A Renminbi fund
funds raise a lot of their money from state-owned manager will rarely have his own capital locked up
companies, and many fund managers come from alongside investors, and even more rarely be
SOE background. awarded that handsome share of net profits.
Maximizing profits is generally not the prime goal Renminbi fund differ in other key ways from PE
of SOEs. They provide employment, steer and VC partnerships. The Renminbi funds usually
resources to industries favored by government have relatively flat pay scales, modest bonuses
plans and policies. A similar mindset informs the and a consensus approach with often as many as
way many Renminbi funds operate. Individual 20 or more staff members deciding on which deals
greed along with individual initiative are to do. A typical dollar-based PE fund in China
discouraged. There are no big pay-outs to partners. might have a total of 15 people, including
In fact, in most cases, there are no partners secretaries. A Renminbi fund? Teams of over 100
whatsoever. are not all that uncommon. A dollar PE firm
investing billions may have an investment
This represents a significant departure from the committee of as few as five people. Partners
partnership structure of private equity and venture decide which deals to do. A Renminbi firm will
capital firms elsewhere. Partnership structure often have ICs with dozens of members, and even
matters because it efficiently harnesses the greed then, their decisions are often not final. Often
of the people doing the investing. The General Renminbi funds need to get investors approval for
Partners (“GPs”) usually put a significant each individual deal they seek to do. They don’t
percentage of their own money into deals have discretionary power, as PE partnerships do,
alongside that of the Limited Partners who capital over their investors’ money.
they invest. GPs are also highly incentivized to
earn profits for these LPs. The usual split is 1:4,
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Renminbi funds have abundant manpower to scout China’s self-made entrepreneurs, this isn’t the sort
for deals across all of China, and can throw a lot of of message they want to hear from an investor.
people into the deal-screening and due diligence They like dealing with partners who have decision-
process. This bulk approach has its advantages. It making power, their own money at stake alongside
can sometimes take a few months of on-the-spot the entrepreneurs. PE partners almost always take
paper-pushing, coaching and reorganizing to get a a personal role in an investment by joining the
Chinese private company into compliance with the board. In short, the PE partner acts like a
legal and accounting rules required for outside shareholder because he is one, directly and
investment. Dollar funds don’t have that capacity, indirectly.
in most cases.
At a Renminbi fund, the managers do not have
Also, Renminbi fund managers often have similar skin in the game, nor a clear financial reward from
backgrounds to the middle management teams at making a successful investment. A Renminbi fund
private companies. They are comfortable with all manager can be fired or marginalized by his bosses
the dining, wining, smoking and karaoke-ing that at any time during the long period (generally at
play such a core part of Chinese business life. The least 3-5 years) from investment to exit. Private
dollar funds? From partners on down, they are equity investing has long time horizon, and the
staffed by Chinese with elite educations, often partnership structure is probably the best way to
including stints in the US working or keep everyone (GP, LP, entrepreneur) engaged,
studying. Usually they don’t drink or smoke, and aligned and committed to the long-term success of
prefer to get back to the hotel early at night to a company.
churn through the target company’s profit forecast.
It is possible for Renminbi funds to organize
Kill-joys though they may be, the PE dollar funds themselves as partnerships. But, few have done so,
still have, in my experience, some large – and and it’s unlikely many will. The GP/LP structure is
most likely decisive — advantages over the supremely hard to implement in China. Those with
Renminbi funds. Decision-making is nimble, the money generally don’t accept the principle of
transparent and centralized in the hands of the giving managers discretionary power to invest, and
firm’s few partners. If they like a deal, they can also don’t like the idea of those managers making
issue a term sheet the same day. At a Renminbi a significant sum from deals they do.
fund, it can take months of internal meetings,
report-writing and committee assessments before All signs are that Renminbi funds will continue to
any kind of term sheet is prepared. grow strongly in number and capital raised. This is,
overall, highly positive for entrepreneurship in
It’s often futile to try to figure out who really calls China. Hundreds of billions of Renminbi equity
the shots at a Renminbi fund. Private company capital is now available to private companies. As
bosses, including several of our clients, are often recently as three years ago, there was hardly any.
loath to work with organizations structured in this Less clear, however, is how efficiently that money
way. The boss at one of our clients recently chose will be invested. I know from experience that
to take money from two dollar PE firms because he Renminbi funds find and invest in great companies.
couldn’t get a meeting with the boss of the well- But, they also are prone to a range of inefficiencies,
known Renminbi fund that was courting him hard. from bureaucratic decision-making to a lack of real
That firm compounded things by explaining the accountability among those investing the
fund’s boss was anyway not really involved in money, that can adversely impact their overall
investment decision-making and would certainly performance.
not join our client’s board.
One way or the other, Renminbi funds will rewrite
The message this sent: “nobody is really in charge, the rules for private equity investing, and
so if we invest, you are on your own”. For a lot of eventually provide a huge amount of data on how
7
well these managers can do compared to PE ICBC, CIIC, andBank of China. The assumption
partners. Our guess is that Renminbi firms will not among many market players was that the HKSE’s
achieve as high a return as dollar-based PE firms growth would continue to surge, thanks largely to
investing in China. The reason is simple: investing Chinese listings, for years to come. With the US,
absent of greed is often investing absent of profit. Europe and Japan all in the economic and capital
market doldrums, the investment banking flotilla
came sailing into Hong Kong. Champagne corks
popped. High-end Hong Kong property prices,
already crazily out of synch with local buying
power, climbed still higher.
The “OTCBB-ization” of The underwriting business relies rather heavily on
the Hong Kong Stock hype and boundless optimism to sell new securities.
It’s little surprise, then, that IPO investment
Exchange bankers should be prone to some irrational
exuberance when it comes to evaluating their own
From the world’s leading IPO stock market to a career prospects. The grimmer reality was always
grubby financial backwater with the sordid
starkly clear. For fundamental reasons visible to all
practices of America’s notorious OTCBB. Is this
but ignored by many, the flood of quality Chinese
what’s to become of the Hong Kong Stock
IPOs in Hong Kong was always certain to dry up. It
Exchange ?
has already begun to do so.
We see some rather disturbing signs of this
In 2006, the Chinese government closed the legal
happening. Underwriters, with the pipeline of
loophole that allowed many PRC companies to
viable IPO deals drying up, are fanning out across
redomicile in Hong Kong, BVI or Cayman Islands.
China searching for mandates and making
This, in turn, let them pursue IPOs outside China,
promises every bit as mendacious and self-serving
principally in the US and Hong Kong. Every year,
as the rogues who steered so many Chinese
the number of PRC companies with this “offshore
companies to their doom on the US OTCBB.
structure” and the scale and growth to qualify for
The Hong Kong Stock Exchange (“HKSE”) may be an IPO in Hong Kong continues to decline. A
going wrong because so much, until recently, was domestic Chinese company cannot, in broad terms,
going right. Thanks largely to a flood of IPO have an IPO outside China.
offerings by large Chinese companies, the HKSE
Some clever lawyers came up with some legal fixes,
overtook New York in 2009 to become the top
including a legally-dubious structure called
capital market for new flotations. While the IPO
“Variable Interest Entity”, or VIE, to allow domestic
markets turned sharply downward last year, and
Chinese companies to list abroad. But, last year,
the amount of IPO capital raised in Hong Kong fell
the Chinese Ministry of Commerce began moving
by half, the HKSE held onto the top spot in 2011.
to shut these down. The efficient, high-priced IPO
US IPO activity remains subdued, in part due to
machine for listing Chinese companies in Hong
regulatory burdens and compliance costs heaped
Kong is slowly, but surely, being starved of its fuel:
onto the IPO process in the US over the last
good Chinese private companies, attractive to
decade.
investors.
During the boom years beginning around 2007, all
Yes, there still are non-Chinese companies like
underwriting firms bulked up by adding expensive
Italy’s Prada, Russia’s Rusal or Mongolia’sErdenes
staff in expensive Hong Kong. This includes global
Tavan Tolgoi still eager to list in Hong Kong. There
giants like Goldman Sachs, Citibank and Morgan
is still a lot of capital, while listing and compliance
Stanley, smaller Asian and European firms like DBS,
costs are well below those in the US. But, the Hong
Nomura, BNP Paribasand Deutsche Bank and the
Kong underwriting industry is staffed-up mainly to
broking arms of giant Chinese financial firms CITIC,
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do Chinese IPOs. These guys don’t speak Russian company theoretically can go public in Hong Kong
or Mongolian. whenever it likes, rather than wait in an IPO queue
of uncertain length and duration, as is true in
So, the sorry situation today is that Hong Kong
China.
underwriters are overstuffed with overhead for a
“coming boom” of Chinese IPOs that will almost In other words, the discussion concerns just about
certainly never arrive. China-focused Hong Kong everything of importance except the fact that
investment bankers are beginning to show signs of valuation levels in Hong Kong are awful, and there
growing desperation. Their jobs depend on winning is a decent probability a Chinese company’s HK
mandates, as well as closing IPOs. To get business, IPO will fail. This is particularly the case for
the underwriters are resorting, at least in some Chinese companies with less than USD$25 million
cases, to behaviors that seem not that different in net income. The cost to a Chinese company of a
from the corrupt world of OTCBB listing. This failed IPO is a lot of wasted time, at least a million
means making some patently false promises to dollars in legal and accounting bills as well as a
Chinese companies about valuation levels they stained reputation.
could achieve in an Hong Kong IPO.
There is, increasingly, a negative selection bias.
The reality now is that valuation levels for most of Investors rightly wonder about the quality of
the Chinese companies legally structured for IPO in Chinese companies, particularly smaller ones,
Hong Kong are pathetically low. Valuations keep being brought to market by underwriters in Hong
getting slashed to attract investors who still aren’t Kong.
showing much interest. Underwriters are finding it
“No one has a crystal ball”, is how one Hong Kong
hard to solicit buy offers for good Chinese
underwriter, a managing director who spends most
companies at prices of six to eight times this year’s
of his time in China scouring for mandates,
earnings. Some other deals now in the market and
explains the big gap between promises made to
nowhere near close are being priced below four
Chinese bosses, and the sad reality that many then
times this year’s net income. At those kind of
encounter. In a real sense, this is on par with him
prices, a HK IPO becomes some of the most
saying “I’ve got to do whatever I’ve got to do to
expensive equity capital around.
earn a living”. He can hold onto his job for now by
In their pursuit of new mandates, however, these bringing in new mandates, then hope markets will
Hong Kong underwriters will rarely share this turn around at some point, the valuation tide will
information with Chinese bosses. Instead, they rise, and these boats will lift. This too is a business
bring with them handsomely-bound bilingual IPO strategy used for many years by the OTCBB
prospectuses for past deals and suggest that advisor crowd.
valuation levels will go back into double digits in
The OTCBB racket is now basically shut down.
the second half of this year. In other words, the
Those who profited from it are now looking for
pitch is, “don’t look at today’s reality, focus instead
work or looking elsewhere for victims, er mandates.
at yesterday’s outcomes and my rosy forecast
Tiny cleantech deals are apparently now hot.
about tomorrow’s”.
Our prediction is a similar retrenchment is on the
This is the same script used by the advisors who
way in Hong Kong, only this time those being
peddled the OTCBB listings that damaged or
retrenched won’t be fast-buck types from law firms
destroyed so many Chinese companies over the
and tiny OTCBB investment banks no one has
last five years. Another similar tactic used both by
heard of. Instead, it’ll be bankers with big salaries
OTCBB rogues and HK underwriters is to pray on
working at well-known brokerage companies. The
fear. They suggest to Chinese bosses that they
pool of IPO fees isn’t big enough to feed them all
should protect their fortune by listing their
now. And, that pool is likely going to evaporate
company offshore, at whatever price possible and
further, as fewer Chinese companies sign on for
using whatever legally dubious method is
Hong Kong listings and successfully close deals.
available. They also play up the fact a Chinese
9
The CSRC Disciplines the The CSRC’s approach to IPO screening is not
dissimilar to the way Goldman Sachs chooses
IPO Process in China companies to underwrite. Each is trying to select
“sure bets”, companies that won’t prove an
embarrassment a few year’s down the
road. Goldman does it to make money and keep its
By turns mysterious, unpredictable, overextended high reputation, the CSRC to avoid social upheaval.
yet under-experienced, byzantine in its complexity
Keeping China’s stock markets scandal free is a
and frustrating for all who deal with it, the CSRC
matter of paramount national importance. So far,
(“证监会”) comes in for a lot of criticism. The
the CSRC has succeeded at this.
Chinese stock market regulator makes and
enforces the rules for all 3,200 public companies
Accounting and disclosure scandals have become
traded on the Shanghai and Shenzhen stock
commonplace for Chinese companies quoted in
exchanges. Though modeled after the US SEC, the
Hong Kong and the US. Not in China. Credit the
CSRC’s remit is far broader. It alone decides which
CSRC’s thorough IPO filtering. The CSRC also
companies will be allowed to IPO. It plays
keeps a tight lid on the supply of IPOs each year
gatekeeper, not just referee.
to prevent new issues from weighing down overall
market valuation.
To win CSRC approval, it is by no means enough,
as it usually is in the US, to have an underwriter
There is another overlooked benefit to the CSRC’s
and a few years of audited financials. All of the
stringent IPO approval process. It weeds out the
seven hundred IPO aspirants waiting in the queue
flim-flammery, hype and exaggerated
for CSRC approval have these. Only a small
salesmanship from the IPO process. Any company
minority will manage to jump through all the CSRC
approved by the CSRC for an IPO is all but
hoops and win approval for an IPO. The CSRC
guaranteed a successful closing. The underwriters
makes its own judgment about a company’s
have it easy. They barely need to break a sweat.
business model, future prospects, management
caliber, shareholder structure, customer
concentration, competitive position,planned use of The same is most definitely not the case in the US
IPO proceeds, the cleanliness of any outside and Hong Kong, for example. There, regulatory
investor’s money, related-party transactions, the approval is the first and simplest step in an
appropriate IPO valuation, even the marital status expensive, tightly-choreographed, quite often
of a company’s founder. unsuccessful effort by underwriters to drum up
investor interest and get them to bite. It involves a
fair bit of hucksterism. In the US, IPO
In effect, the CSRC is doing its utmost to take the
underwriters are salespeople. In China, they are
“caveat” out of “caveat emptor”, by detecting
order-takers.
ahead of time any taint that could damage a
company’s post-IPO process. The CSRC can of its
own volition forbid companies in an industry to IPO, Chinese underwriters have limited discretion over
as it did recently with real estate developers and IPO pricing. For one thing, the CSRC is watching,
private steel companies. The purpose is to starve and can deal severely with underwriters who seek
them of capital. It can also, just as suddenly, what the CSRC decides are “overpriced” valuations.
reverse its prior course and allow once-blacklisted It seems like everyone in China knows where IPO
industries to access public markets. It seems to be valuation multiples are at any given time. At the
doing this now with Chinese companies in the moment, they are around 35 times last year’s net
restaurant industry. It can also play favorites. income for smaller companies listing on the
Companies from China’s restive Xinjiang region are Chinext, and around 25 times for larger
currently given special priority, and shown more companies. The CSRC has grown increasingly
leniency, in approving IPOs. vocal in criticizing big first day gains for newly-
IPO’d companies.
10
The CSRC does not approve IPO applications of “safety first” seems a good principle for China at
companies that don’t have at least two years of this stage. Private companies have only had access
profits or ones that have huge numbers of users, to China’s capital markets, in a substantial way, for
but comparatively light profits. That is to say, no two years, with the opening of the Chinext (创业板）
Facebook, Groupon or Linkedin types are allowed. board.
This, too, removes a lot of the investment banking
sales wizardry seen in the US during the IPO The stock market is now –and will remain — the
process. lowest cost way to finance the growth of private
enterprise in China. Everyone stands to lose
One positive result of this is that underwriters in if confidence is badly shaken, or a scandal takes
China are limited in what they can promise down one of these once-private now-public
companies to win an IPO mandate. Good, bad or companies. For this reason, though many
indifferent, an underwriter is likely to get just investment professionals are mystified by its
about the same price for shares it sells in an IPO. decisions and sudden about-faces, the CSRC
So, basically, winning mandates in China comes deserves support and respect.
down to a lot of wining and dining, Karaoke and
cartons of expensive cigarettes.
Since the CSRC’s approval process can drag on for
up to two to three years, underwriters also have
little, to no, say over IPO timing. The risk in the Teaching the Elephant to
IPO process in China is, overwhelmingly, the risk
of rejection by the CSRC. The CSRC rules mean
Dance – China’s SOEs
underwriters and company are in it together. The Transform
underwriter needs to be active throughout the long
process, and present at many meetings with the
CSRC. The underwriters put their neck on the line
by providing guarantees to the CSRC on the
Over the last thirty years, China has gone from a
country where just about all companies were state-
soundness of a company’s financials and pre-IPO
owned enterprises (so-called “SOEs”) to one where
disclosure.
now fewer than 30% are. Much of the dynamism in
China’s domestic economy comes from these
Having seen the process from both angles, ten
newer private companies. There are some very
years ago as CEO of a US company during part of
strong SOEs dominating key sectors of China’s
its IPO process, and now in China, working with
economy, including China Mobile, Sinopec, ICBC
clients seeking CSRC approval, my view is that the
and other large banks, as well as airlines and
CSRC’s method has a lot to recommend itself. It
utilities. These companies have also been partially
puts far more focus on the company and less on its
privatized by selling minority stakes on global
investment banker. An IPO in China is not so much
stock markets. This has provided huge amounts of
a test of an underwriter’s marketing prowess and
new capital and brought with it improved
placement network, but more state-directed capital
performance and corporate governance at these
deployment to companies deemed by the CSRC to
top SOEs.
be most suitable and fit to receive a slice of the
public’s savings. Who the underwriter is and how
But, many SOEs have failed, while others languish
they operate are basically afterthoughts.
with inefficient production, overstaffing and
outmoded products. For many of these, the
This may offend against the market principles of a
prognosis is not good. But, at the same time, there
lot of financial professionals, that the only real IPO
is a entrepreneurial transformation getting
test a company should need to pass is if an
underway at some of these SOEs. Managers are
investor will send a check to buy its shares. But,
beginning to act more like owners and less like civil
11
servants. We are seeing this now in our work. industry in China. Its profits this year should
Some of the most interesting companies we’re exceed Rmb 650mn (USD$100mn).
talking to are SOEs eager to bring in outside
capital as a first step towards privatization, and Because the parent company is already public, this
subsidiaries of larger SOEs looking for ways to split subsidiary needs to fight for capital with other
themselves off from their parent and go public larger sister companies inside the conglomerate. It
independently. usually comes up short. With access to new capital,
the subsidiary’s current managers are confident
We expect to see more and more private capital, they could double the size of the business (both
particularly from private equity firms, going into profits and revenues) within two to three
SOEs. In some cases, the investors will find ways years. Outside of China, spinning off a subsidiary
to take majority control. In others, they will link or selling a minority stake in an IPO is a fairly
their minority investment to a corporate straight-forward process. Not so in China.
restructuring that gives the SOEs management
equity, warrants, or other incentives to improve Under current rules, the CSRC, China’s stock
performance and profitability. market regulator, will not allow the parent simply
to spin off the subsidiary through an IPO. There
The likely result: some of China’s more tired SOEs are related party transactions and deconsolidation
are going to get a big dose of free market issues. So, we are looking at ways for a large
adrenalin. At the moment, there are lots of legal strategic investor to buy a controlling stake in the
hurdles for private capital to enter into an SOE. subsidiary, then pour in as much as $250mn in
The process is opaque. We’re spending a fair bit of new capital. The subsidiary will then build up its
time on behalf of several SOEs trying to figure out business to where it could either qualify for an IPO
workable legal mechanisms. To succeed, any deal three to five years later, or sell itself back to the
will take time and need champions in higher levels parent.
of government. But, practical economic policies
tend to triumph in China. Private capital is, without The management of this subsidiary is quite keen to
question, the best option to improve the put in their own money and become shareholders
profitability and future prospects of many SOEs. if their business can be separated and put on a
This is good for employment, good for economic path to IPO. They have done a very solid job
growth, good for worker incomes, good for building the business to its current scale, and
accelerating development in inland China. These would likely do markedly better if they had a real
are all core policy goals in China. stake in the performance of the company.
We’re not able to discuss details or provide In another deal we are working on, a chemical
company names, but can give an outline of several company now majority owned by Sinopec is
of the most interesting SOE transactions we are bringing in new capital to buy the Sinopec shares
now working on. This should give a sense of the and recapitalize the business. The company was
kind of changes that may be on the way for SOEs. started seven years ago by a private entrepreneur,
who raised the original capital from Sinopec. The
In one case, a subsidiary of one of China’s largest entrepreneur now controls about 40% of the
publicly-traded SOE construction holding company’s equity. Through the deal we’re working
companies is looking for ways, with the parent on, he will become the majority owner and the
company’s encouragement, to spin itself off, raise private equity investor will own the rest.
private equity capital, and then try for an IPO.
Though it contributes only about 5% of the parent We’re also in discussions with the international
company’s total revenues and operates in different division of one of China’s giant SOE electricity
markets than the parent, this subsidiary is one of companies. This group already has sizable projects
the largest, most successful companies in its and revenues in Southeast Asia and Russia, where
12
it built and operates large hydro and gas-fueled
Xinjiang is Changing the
power plants. The international division, however,
is being held back by high debt levels at the SOE Way China Uses and
parent. This means the international division has Profits from Energy
trouble borrowing enough to finance its continued
growth. Since the international division is already
structured legally as a Hong Kong company, it
The Two truisms about China should carry the
should be possible for it to raise private equity
disclaimer “except in Xinjiang”. China is a densely-
then IPO in Hong Kong. We think this division can
populated country, except in Xinjiang. China is
raise as much as USD$500mn in the next three
short on natural resources, except in Xinjiang.
years, both in private equity and IPO.
Representing over 15% of the China’s land mass,
but with a population of just 30 million, or 0.2% of
These three (the construction subsidiary, the
the total, Xinjiang stretches 1,000 miles across
chemical company and international power plant
northwestern China, engulfing not only much of
business) are all very solid businesses that outside
the Gobi Desert, but some of China’s most arable
investors will likely flock to. We’re also trying to
farmland as well. Mainly an arid plateau, Xinjiang
find a way to help a more troubled smaller SOE
is in places as green and fertile as Southern
based in central China. They make certain types of
England.
special fiberglass. The core business is
fundamentally sound, but is stuck also doing some Underneath much of that land, we are beginning to
other things that lose money. It is too small now learn, lies some of the world’s largest and richest
to qualify for an IPO, and is having a hard time in natural resource deposits, including huge
the current environment increasing its bank quantities of minerals China is otherwise
borrowing. The existing managers are eager to desperately short of, including high-calorie and
have an outside private equity investor come in clean-burning coal, copper, iron ore,
and not only provide the capital, but also help petroleum. How, when and at what cost China
improve manufacturing efficiency and marketing, exploits Xinjiang’s natural resources will be among
and chop away the loss-making parts. They think the deciding issues for China’s economy over the
an investment of Rmb 50mn could increase profits next thirty years. Already, some remarkable
by a similar amount within two years. progress is being made, based on two past visits
Because of its vast size and small population,
As anyone with experience will tell you, working
Xinjiang hasn’t yet had its mineral resources fully
with SOEs can be a complicated and time-
probed and mapped. But, every year, the size of
consuming process, particularly compared to
its proven resource base expands. Knowing there’s
dealing with a company founded and run by a
wealth under the ground, and finding a cost-
private entrepreneur. But, the changes underway
effective way to dig out the minerals and get them
at SOEs represent ones of the most significant
to market are, of course, very different things.
transformations now taking place in China’s
Until recently, Xinjiang’s transport infrastructure –
economy. With new capital and perhaps new
roads and railways – was far from adequate to
ownership structures, many SOEs are going to
provide a cost-efficient route to market for all the
thrive as never before. Their greater efficiency and
mineral wealth.
greater profits will be a challenge for the private
sector, but overall will be a plus for China. That bottleneck is being tackled, with new
expressways opening every year, and plans
underway to expand dramatically the rail network.
But, transport can’t alter the fact Xinjiang is still
very remote from the populated core of China’s
fast-growing industrial and consumer economy.
Example: it can still be cheaper to ship a ton of
13
iron ore from Australia to Shanghai than from return for the company’s agreement to invest and
areas in Xinjiang. build the large chemical factory next to it. The cost
of producing PVC at this plant should be less than
Xinjiang’s key resource, and the one with the
one-third that of PVC made using petroleum.
largest potential market, is high-grade clean-
China’s PVC market, as well as imports, are both
burning coal. Xinjiang is loaded with the stuff, with
staggeringly large. The new plant will not only
over 2 trillion tons of proven reserves. Let that
lower the cost of PVC in China but reduce China’s
figure sink in. It’s the equivalent of over 650 years
demand for petroleum and its byproducts.
of current coal consumption in coal-dependent
China . The Chinese planners’ goal is for Xinjiang Another company, one of the largest private
to supply about 25% of China’s coal demand within companies in China, is using its Xinjiang coal
ten years. reserve, again supplied for free in return for
investment in new factories, to power a large
Xinjiang’s coal is generally both cleaner (low
chemical plant to produce glycerine and other
sulphur content) and cheaper to mine than the
chemical intermediates. This company is already a
coal China now mainly relies on, much of which
large producer of these chemicals at its factories in
comes from a belt of deep coal running through
Shandong. There, they run on petroleum. In the
Inner Mongolia, Shanxi and Shandong Provinces.
new Xinjiang facility, coal will be used instead,
Large coal seams in Xinjiang can be surface mined.
lowering overall manufacturing costs by at least 20%
Production costs of under Rmb150 a ton are
– 30% based on an oil price of around $50. At
common. The current coal price in China is over
current oil prices, the cost savings, and margins,
four times higher for the dirtier, lower-energy stuff.
become far richer.
For all its advantages, Xinjiang coal is not going to
The key, of course, is that the companies get the
become a primary source of energy in China. The
coal reserve for free, or close to it. True, they need
Chinese government, rightly, understands that the
to build the coal mine first, but generally, that isn’t
cost, complexity and long distances involved make
a large expense, since it can all be surface-
shipping vast quantities of Xinjiang coal to Eastern
mined. This means that the cost of energy in
China unworkable. Moving coal east would
these very energy-intensive projects is much lower
monopolize Xinjiang’s rail and road network,
than it would be for plants using petroleum or, to
causing serious distortions in the overall economy.
be fair, any operator elsewhere who would need to
Instead, the Xinjiang government is doing purchase the coal reserve as well as build the
something both smart and innovative. It is capital-intensive downstream facilities.
encouraging companies to use Xinjiang’s abundant
The Xinjiang projects should lock-in a significant
coal as a feedstock to produce lower cost supplies
cost advantage over a significant period of time. As
of industrial products and chemicals now produced
investments, they also should provide consistently
using petroleum. All kinds of things become cost-
high returns over the long-term. While the capital
efficient to manufacture when you have access to
investment is large, we’re confident the projects
large supplies of low-cost energy from coal.
are attractive on risk/return basis, and that in a
Shipping finished or intermediate goods is
few years time, these private sector “coal-for-
obviously a better use of Xinjiang’s limited
petroleum” projects will begin to go public, and
transport infrastructure.
become large and successful public companies.
I’ve seen and met the bosses of several of these
The Xinjiang government keeps close tabs on this
large coal-based private sector projects in Xinjiang.
process of providing free coal reserves for use as a
The scale and projected profitability of these
feedstock. Since in most cases, these projects are
projects is awesome. In one case, a private
looking to enter large markets now dominated by
company is using a coal mine it developed to
petroleum and its byproducts, there is ample room
power its $500mn factory to produce the plastic
for more such deals to be done in Xinjiang.
PVC. The coal reserve was provided for free, in
14
Deals are getting larger. China’s largest coal Despite its scale and global importance, this
producer, Shenhua Group, announced it would company is never listed among the biggest private
invest Rmb 52 billion ($8 billion) on a coal-to-oil companies in China. Its owner is never included
project in Xinjiang. The company plans to mine 70 among the ranks of the country’s private sector
million tons of coal a year and turn it into three billionaires. Just how unknown is this remarkably
million tons of fuel oil. successful entrepreneur? Here’s one measure.
Believe me, I’m a big nobody in China. But, a
Remote and sparsely-populated as it now is,
Baidu search turns up more articles and references
Xinjiang is going to play a decisive role in China’s
to me and my company than to this company boss
industrial and energy future, just as the
and his. In terms of orders of magnitude, his
development of America’s West has helped drive
company employs about 2,000 times more people
economic growth for over 100 years, and created
than mine, and occupies a premises that’s about,
some of America’s largest fortunes. Our
well, 190,000 times larger.
prediction: China’s West will produce more coal
and mineral billionaires over the next 100 years
None of my competitors, as well as virtually no
than America’s has over the past hundred.
credible PE firms, have visited the company. My
purpose here is two-fold: to shed a little light on a
remarkable individual entrepreneurial achievement
and also to give some sense of the scale of
entrepreneurial greatness in China. I find myself,
"If You Are Going to Do more often than I’d like, drawn into discussions –
Something, Do It Big" occasionally arguments – with people in the US
and Europe about how entrepreneurship in China is
in a class by itself, compared to everywhere else in
the world, excepting perhaps the US and Israel.
The first thing that strikes you is complete
geographic implausibility of it all. In a rural corner
Entrepreneurs are more numerous here (over 70
of the sparsely-populated and dusty Loess Plateau
million private companies) and the best ones,
in Northwestern China, sits an enormous complex
numbering at least in the thousands, have created
of factories, dormitories, roads, and train tracks
more wealth and spawned more positive societal
occupying an area of 38 square kilometers (14.6
progress in the last ten years than any other single
square miles, almost 19 million square feet).
group of people on the planet. I live in a perpetual
That’s over half the size of Manhattan, 58 times
state of wonder, doing what I do for a living in
larger than LA’s Disneyland, three times larger
China, having occasion to meet entrepreneurs of
than the world’s busiest international airport,
the caliber of this particular boss.
Heathrow in London.
He is about as modest an individual as you would
The site belongs to a single Chinese company. It’s
likely ever run across. The only obvious concession
private, been in business less than a decade, has
to his enormous wealth is a rose gold watch he
come from nowhere to become the world’s largest
wears along with standard-issue baggy Chinese
manufacturer of a critical component used in steel
suit. If he sat next to you on a plane, my guess is
production, with likely revenues this year of over
you’d pin him as the owner of a small hardware
USD$1.5 billion (Rmb10 billion), profits of over
store, not the owner of the world’s largest
USD$130 million , and assets of over USD$2.4
manufacturing business for a component used in a
billion (Rmb 15 billion). It’s 99% owned by its
lot of what’s for sale there.
founder and chairman, with the other 1% held by
his wife and daughter. By any measures, it is
among the largest private industrial companies in His office is hardly palatial, and sits just above the
the world, and certainly among the fastest ever to oldest section of his giant factory complex. He
get to $1 billion in sales. never went to college, and has no engineering or
15
technical background, despite founding and now Just about every “yuan” of profit he earns is
running one of the more complicated large-scale poured back into expanding production. His bank
engineering and manufacturing businesses you’d loans are moderate – about 10% of total assets.
ever hope to see. He’s only drawn down 70% of the credit lines
provided by local banks. Measured by scale
Everything about the man, except his ego, is huge. (factory size, employees, revenues) his company is
“If you are going to do something,” he tells me, similar to many larger SOEs in China. Asked to
“do it big.” This applies not only to the huge area make a comparison, he explains that SOEs target
his business occupies, but the size of the only top line growth — girth for its own sake. He is
investments he is making in its future. He is taking far more focused on making money. The projected
his business downstream and building, annual rate of return on newer projects is well
simultaneously, at least four huge new production above 25%.
sites, with total planned investment of over $3
billion. The local government is busy decapitating He’s thinking about an IPO within two to three
the top half of a silt mountain to create a level 500 years. His business could have a market
acre site (about one square mile) for one of these capitalization at that point in excess of USD$8
new production areas. He begins building on it this billion. An IPO on that scale will bring him a lot of
year. unwanted notoriety. He would likely instantly be
vaulted into the ranks of the five hundred richest
As I drove away from the factory area, I remarked people on the planet. Billionaires in China rarely
to my colleague that the whole complex must be a have it easy. Quite a few seem to end up in prison,
source of intense interest at the CIA and National or targeted by waves of bad publicity. For him, the
Security Agency in Washington, DC. Satellite real appeal of going public is the potential to raise
photos will show the vast scale of this enterprise, an additional $1.5 billion to $3 billion to invest in
as well as all the construction taking place. One further downstream expansion.
recently-completed building is four stories tall and
a mile long, all indoors. It was one of the great delights of my 35-year
professional career to meet this entrepreneur, tour
My guess is the two spy agencies aren’t all that his factories and eat in his dining room. At this
sure what exactly is being produced or planned moment in history, China is the entrepreneurial
here. I drove through it. Within a year, it will start center of the world.
producing steel products for the auto and home
appliance industry.
--- Peter Fuhrman
Chairman
How did this one entrepreneur build such a huge
business is such a short time? Obviously, good
timing, luck, some support from his local CHINA FIRST CAPITAL
government and banks played a part. But, one key
Tel: 0755 33222101
factor was a gamble he made in 2008 that paid off Email: ceo@chinafirstcapital.com
big time. When the financial crisis hit, his state- Website: www.chinafirstcapital.com
owned competitors (there were once three within a
few hundred miles of him) cut way back on raw
material purchases. This boss did the opposite. He
exploited a steep drop in commodity prices, bought
© China First Capital. All contents are exclusive content of China First Capital and
big and so locked in very large profits when may not be reprinted or republished without written consent of China First Capital
customer demand began to pick up in 2009. Of
course, had prices kept falling, he would have
likely been bankrupt. His state-owned competitors?
Now, all out of business.
16
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