"Private Equity in China, 2012 - 2013"
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 2 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 3 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, 4 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, 6 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, 8 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: firstname.lastname@example.org 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