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PE in China 2012-2013 The Pace of Change Accelerates


Proprietary research report on private equity and capital markets in China, published by China First Capital (中国首创) a specialist international investment bank

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    Private Equity in China 2012
    The Pace of Change Quickens
























 Dollars No Longer Welcome
 Cornerstone Investing
 Valuation Arbitrage                                     6
 Focus Media LBO                                         7
 Jiuding Capital                                         9
 China M&A                                              12
 Private Equity Valuation: Terminal Multiple            13
 Government Support for Business                        15




               Dollars No Longer                             for one-third of all IPOs in the US. The IPO market
                                                             for Chinese companies listing in Hong Kong was
                   Welcome                                   even hotter. Last year, almost $70 billion was
                                                             raised by Chinese companies listing on the Hong
                                                             Kong Stock Exchange.

2012 is going to be a bad year for new dollar                Dollars raised in New York or Hong Kong IPOs were
investing in Chinese financial assets. This reverses         converted into Renminbi, then invested to fuel the
what was thought to be, only a few years ago, an             growth of hundreds of Chinese private companies
irreversible trend as more of the world's largest            and SOEs. Stock markets in London, Frankfurt,
and most sophisticated investors sought to                   Seoul, Singapore, Sydney also provided access for
increase the asset allocation in China. It's not that        Chinese companies to list and raise capital there.
China has fallen out of favor with institutional             Overall, the international capital markets have
investors. If anything, China's comparative                  been a key source of growth capital for Chinese
strengths -- in terms of solid economic growth, a            companies, and so an important part of China's
vibrant domestic consumer market, reasonably                 overall economic transformation.
healthy banks -- stand in ever starker contrast
with the insipid economies of Europe, the US,                This year, the US will probably host fewer than five
Japan.                                                       Chinese IPOs, and the total amount raised by
                                                             Chinese companies in Hong Kong will be down by
So, how come fewer dollars are flowing into China?           at least 65% from last year. The two other sources
The main reason is that the stock markets in the             of dollar investment in Chinese companies --
US and Hong Kong have fallen out of love with                private equity and institutional purchases of
Chinese IPOs. These two stock markets have been              Chinese shares -- are also trending downward. Of
the primary source for more than a decade of new             the two, PE money was by far the more important,
dollar funding for domestic Chinese companies.               particularly over the last decade. In a good year,
Just two years ago, Chinese companies accounted              over $5 billion of capital was invested into private

Chinese companies by PE firms. But, rule changes        China would be felt acutely by Chinese companies.
in China began to make dollar PE investing more         But, as dollar investing has dried up, Renminbi
difficult starting five years ago. It's harder now to   investing has more than filled the gap. The
get permission to convert dollars into Renminbi,        Shenzhen and Shanghai stock markets are now far
and Chinese companies can no longer easily create       larger sources of fresh IPO capital for Chinese
offshore holding company structures to facilitate       companies than New York or Hong Kong ever were.
dollar investment and an eventual exit through          Also, Renminbi PE firms have proliferated.
offshore IPO.
                                                        For a mix of reasons, China is now, arguably, more
Rule changes slowed, but didn't stop, dollar PE         financially self-reliant than it has been since Mao's
investing in China. The bigger problem now is that      day. Autarky used to be state policy. Now, it is a
stock market investors in the US, and to a slightly     consequence of China's own rising affluence and
lesser extent Hong Kong, no longer want to buy          capital accumulation, together with some
Chinese shares at IPO. It's mainly because retail       nationalistic policy changes and the fall-off in
and institutional investors outside China distrust      interest among international investors to finance
the quality and truthfulness of Chinese corporate       Chinese IPOs. Ironically, as China has been drawn
accounting. If offshore IPOs dry up, dollar PE          more into the global trade and financial system, its
investors have no way to cash out. M&A exit is still    need for external capital has lessened.
rare. The twin result this year: less dollar PE
money entering China, and also a steep drop in          Dollar investment in China benefits both sides. It
offshore IPO fundraising for Chinese companies.         offers dollar investors higher potential rates of
                                                        return than investing in mature developed
Consider what this means: the world's largest           economies. This means better-funded and more
pools of institutional capital are finding it more      generous pensions for American and European
difficult to invest in the world's is fastest growing   retirees. For Chinese companies, dollar investors
major economy. This makes no financial sense.           usually tend to be more hands-on, in a good way,
Chinese companies have a huge appetite for              than Renminbi funds. So, they help improve the
growth capital, and generally can achieve high          overall competitiveness, professionalism, corporate
rates of return for investors. Investment in China's    governance and strategic planning of the Chinese
private entrepreneurial companies remains               firms they invest in. Many of China's best
perhaps the best risk-adjusted investment class in      entrepreneurial companies -- including well-known
the world. But, all the same, this year will see a      firms like Baidu, Alibaba, Tencent, as well as
steep drop of new international investment in           hundreds of domestic Chinese brand-name
Chinese companies.                                      companies few outside of China have heard of--
                                                        were nurtured towards success by dollar investors.
China this year has liberalized the rules somewhat
to allow international institutions to buy shares       Since just about everyone wins from new dollar
quoted in China. But, since that money goes to buy      investing in China, what can be done to reverse
shares held by other investors, rather than to the      this year's big slide? The answer is "not a lot". I
company itself, investing in Chinese-quoted shares      don't see any strong likelihood that international
has little, if any impact, in filling Chinese           investors will grow less allergic to Chinese IPOs.
companies' need for growth capital. The appeal of       Renminbi PE and IPO funding for Chinese
owning China-quoted shares is hardly                    companies will continue to grow strongly. Only the
overpowering, as the market has been a poor             removal of capital controls in China, and full
performer overall, and share prices are more            Renminbi convertibility, would change the current
propelled by rumor than fundamental value.              situation, and lead, most likely, to large new flows
                                                        of offshore capital into China.
At any earlier time in recent history, a dramatic
drop like this year's in new dollar investment into

But, full Renminbi convertibility is nowhere in sight.   time when most IPOs were heavily oversubscribed
For the foreseeable future, China's growth will be       and likely to record a big jump in price. Now, the
financed at home.                                        plutocrats are gone, IPO valuations are down, and
                                                         PE firms have taken their place. What is it they say
                                                         about fools going where wise men dare not tread?

                                                         How popular are these cornerstone deals now in
                                                         Hong Kong? Hundreds of millions of dollars of PE
        Cornerstone Investing: A                         capital is being deployed. According to data from
                                                         Bank of America Merrill Lynch cited by the Wall
        New & Uncertain Strategy                         Street Journal, “private-equity funds… [make] up
          For China PE Firms                             41% of cornerstone investors in Hong Kong IPOs in
                                                         2012, compared with just 5% last year.” The only
                                                         limiting factor seems to be the big falloff in the
                                                         number of Chinese companies going public in Hong
Cornerstone investing is the latest new                  Kong this year. PE firms appetite to do these deals
investment strategy favored by some in the PE
                                                         seems, if anything, to be getting stronger.
industry in China. It is still early. But, cornerstone
deals may prove to be among the least successful
                                                         Finding a cornerstone investor is usually a great
risk-adjusted ways to make money investing in
                                                         deal for the company staging an IPO, since it
Chinese companies. Cornerstone investing
                                                         means there are fewer shares that need to be sold
involves putting big money up to buy shares in a
                                                         to the general public, and the lock-in provisions
company at the time of its IPO. In essence, it's no
                                                         provide comfort to other investors that the
different than buying any other publicly-traded
                                                         company should be worth more later than it is at
share through your stockbroker, except a little
                                                         time of IPO. So, price volatility is reduced.
worse in one respect. The cornerstone investors
usually accept restrictive covenants that prevent
                                                         And the corresponding benefits for the PE firm are?
them from exiting until months after the IPO. The
                                                         The PE firms will claim they are buying into a good
investment strategy, such as it is, amounts of
                                                         company at a comparatively good price, that
hoping the stock price will go up.
                                                         they’ve done extensive DD and are confident of
                                                         long-term stock price appreciation, with moderate
This is obviously quite a departure from the way PE
                                                         to low risk. In other words, it’s a good place to
firms typically operate in China: discovering a
                                                         invest their LPs money. That might be more
great private company, putting money in while the
                                                         plausible if cornerstone investing was producing
company is still illiquid, then nurturing their growth
                                                         large returns of late. It hasn’t. The Hong Kong
for several years up to and beyond a public
                                                         stock market remains at a very low level. Yes,
offering. Done well, this process will earn a PE
                                                         maybe the Hong Kong stock market will rally, and
investor returns of 500% or more. Generally, PE
                                                         so lift these shares, conveniently after the lock-in
firms also can indemnify themselves against losing
                                                         has expired, allowing the PE firms a nice trading
money by exercising a put to sell their shares back
to a company that fails to IPO successfully. It's
hard to imagine any scenario where cornerstone
                                                         As an investment strategy, this basically amounts
investing can do as well, and many where it will be
                                                         to market timing. And as most financial theory
significantly worse. One example: the possibility
                                                         teaches us, all market timing is as likely to lose
that stock market performs poorly, as it has in
                                                         money as earn it. The PE firms will argue otherwise,
Hong Kong for the last year or so.
                                                         that they are acting like good “value investors”,
                                                         buying the shares at what they deem to be a low
Cornerstone investing is a well-established practice
                                                         IPO price. As the company grows, its stock price
in Hong Kong IPOs. Previously, it was only rich
                                                         will as well. Could be. But, there is an argument
Hong Kong plutocrats who did these deals, at a

that this is what hedge funds and mutual funds are      making and a PE firm will start to find its LPs are
designed to do. They bet on the earnings                less willing to commit money in the future.
momentum and so share price direction of
publicly-traded equities. Is PE investing in China so   This kind of “DD risk” is largely absent from
difficult, so profit-constrained that PE firms now      cornerstone deals. A company staging an IPO has
need to appropriate someone else’s business             gone through multiple rounds of vetting, approval
model? And do so without having much, if any, of        and audits. All paid for by parties other than the PE
a track record in this sort of investing?               firm. So, cornerstone investing can look, from a
                                                        certain crooked perspective, like typical PE
That’s really the challenge here. Why should PE         investing minus all the costs and hassle of DIY DD.
firms do these deals if there are still many            After all, the companies going public are usually
outstanding pre-IPO equity investment                   similar in scale, business model and growth to
opportunities available in China? PE firms can          purely-private deals the PE firm will look at in
acquire a meaningful ownership stake in a dynamic       China.
private Chinese company, at low valuation, enjoy
all kinds of special investor rights and privileges,    Cornerstone investing is suddenly popular with
including that guaranteed buy-back, that aren’t         some PE firms because stock market valuations
available to cornerstone investors.                     have fallen so far in Hong Kong. Valuations, in p/e
                                                        terms, are usually lower now in a Hong Kong IPO
With cornerstone investing, a PE firm is mainly at      than for a comparable company raising money in a
the mercy of the stock market. Will overall share       private placement in China: 4-8X this year's net
prices go up or down or stay the same? It’s             income for the HK IPOs, and 8-10X for the private
passive. With typical PE investing, the potential       placements.
rewards, as well as downside protections, are
obviously much better. But, so is the work you          PE firms are given money by investors, and usually
need to do.                                             paid an annual management fee, to take on this
                                                        risk and trouble of finding good companies,
That may explain a lot of the appeal of cornerstone     screening them, negotiating a good deal, and then
investing. Cornerstone investing is simple. You get     remaining actively engaged, after investment, on
the IPO prospectus from a well-known underwriter,       the board, to help the company achieve its targets
parse the audited financials, study other quoted        and an eventual exit. This is where the big money
comps, maybe talk to management about their             has been made in China PE, not in betting on the
growth prospects and how the IPO proceeds will be       direction of publicly-traded share prices.
spent. You then make a determination about
whether the company looks to be a good medium-          As a stock picking strategy, it’s not unreasonable
to-long term bet. You never need to leave the           to suppose that Hong Kong stock prices are now at
office.                                                 a cyclical low, and will start to move closer to the
                                                        valuations on China’s domestic stock markets. If so,
Compare that to PE deals in China. Due diligence is     then some cornerstone deals may end up making
messy, slow, expensive and hazardous. Many deals        decent money.
never close because the PE firm discovers, during
DD, that a Chinese firm’s financials are not            But, PE firms are not, or should not be, stock-
compliant with tax laws, or the founder’s main          pickers, market-timers, valuation arbitrageurs.
supplier is his cousin’s husband or the company         This is truest of all for those PE firms that raised
has failed to acquire the appropriate licenses. In      money to invest – actively and passionately -- in
these cases, the PE firm has to swallow the cost of     China's outstanding private entrepreneurial
the DD, which can run to $250,000 or more per           companies.
deal. Too many examples of this kind of loss-



         How Valuation Arbitrage
          Can Misprice Chinese
Valuation arbitrage is a fancy term for something       harmonize over time. In illiquid PE investing,
most of us do routinely, and successfully. It’s most    however, the utility – and profit potential -- of
often called “comparison shopping”. If we see two       valuation arbitrage is much less certain. This
shops selling identical apples at widely divergent      doesn’t stop some PE investors from trying,
prices, most of us will probably opt for the cheaper    however.
ones. In investing, a similar principle applies, with
the added benefit of the chance to make real            PE firms are all the time collecting share prices for
money, not just eat cheaper apples. For example,        all kinds of companies, public and private, large
if I can buy copper in Chile for $500 a ton, spend      and small. It can be very useful. If, for example,
$50 to ship to Shanghai, then sell it in China where    you want to buy shares in a private shipyard in
I’m guaranteed a price of $1,000 a ton, I will want     Dalian, it is going to be helpful to look at the price
to buy as much Chilean copper and book as many          of quoted shipyards traded in Shanghai, Shenzhen,
freighters as my bank borrowing allows.                 Hong Kong, New York. Valuation arbitrage is one of
                                                        the reasons PE firms act as cornerstone investors,
Valuation arbitrage is similarly often a smart          or pursue “delist-relist” deals to take private
investment strategy. If shares of two very similar      companies quoted outside China.
companies are trading at very different valuations,
I can speculate that the cheaper one will               At the moment, valuation arbitrage suggests that
appreciate to reach the level of its competitor. In     many private Chinese companies raising PE capital
highly-liquid stock markets, there is often a           are “too expensive”, because competitors in
tendency of prices of similar securities to             Singapore, Hong Kong or the US are trading at
                                                        lower p/e multiples. In such cases, many PE firms

will often walk away. Or, call their broker and buy     Chinese private companies, especially those with
the shares of a cheaper quoted company.                 PE money, will likely follow a very different growth
                                                        trajectory than an already public competitor. So,
But, valuation arbitrage also has its limits, both as   comparisons become difficult. Done right, PE
a tool and as an investment strategy. For one thing,    money will have a transformative effect on a
it tends to get applied selectively in Chinese PE.      business, lifting its performance across every
It’s generally used to argue that private companies     important measure of growth and value. Equity
raising money are too expensive, because of prices      capital acts as a growth hormone, improving
of similar quoted businesses in Hong Kong or New        margins, economies of scale, market share,
York. I’ve yet to hear it used as a rationale for       management depth and talent. It’s not just the
claiming a private company is seriously                 money. The PE firm will impose greater discipline
undervalued because its quoted comps trading in         on decision-making, and put its own resources to
China are at much higher prices. This is usually the    work to improve a company’s products, marketing,
case, since p/e multiples on China's domestic stock     strategy.
market remain very much higher than those
elsewhere.                                              If after raising PE a private company can grow by
                                                        25% faster than its quoted competitors while
A Chinese company trading at 10X p/e today looks        achieving higher net margins, it makes sense to
expensive in Hong Kong, but cheap in Shanghai.          pay a price now that is higher, in p/e terms. PE
The valuation differential now is quite wide: 5X this   firms that rely on valuation arbitrage tend to
year's net income in Hong Kong, and at least 20X        overlook the impact their involvement, with both
in China. I’ve heard it argued, in fact, that this      money and hard work, will have on the company.
represents the ultimate valuation arbitrage             There is rough analogy in particle physics, that by
opportunity, that Chinese companies will all            measuring something we alter the behavior (speed,
someday harmonize at similar p/e levels, meaning        path, placement) of what’s being observed.
those trading in Hong Kong must go up, while            Valuation is volatile. A good company’s
those in Shenzhen or Shanghai must come down.           performance is much less so.

That might happen, for instance if China were to
lift exchange controls and so allow domestic
investors to buy these “cheap” shares in Hong
Kong. Investors have been speculating on this for
                                                                Focus Media-- PEs Try an
years. But, there’s no sign of this happening. For               Onshore/Offshore LBO
now, these Hong Kong/China valuation differentials
can be arbitraged well on paper, but not in practice.

Valuation arbitrage only works when markets and         The first rule of capitalism is the more buyers you
capital flows are fluid and open. This very much is     attract, the higher the price you get. So, having
not the case with Chinese stock markets, and so         just one potential buyer is generally a bad idea
with Chinese companies raising money. They are,         when your goal is to make as much money as
you can say, "non-arbitrageable".                       possible.

Another main failing, though, is more of an             What then to make of the recently-announced plan
conceptual one. Comparing a private Chinese             by an all-star team of some of China's largest PE
company, prior to its raising PE capital, with an       firms, including CDH, Fountainvest, CITIC Capital,
already-public company, Chinese or otherwise, will      as well global giant Carlyle, to participate in a $3.5
quickly veer from the realm of comparative              billion proposed leveraged buyout deal to take
analysis to the realm of pure guesswork.                private the NASDAQ-listed Chinese advertising
                                                        company Focus Media. Any profit from this "take

private" deal, as far as I can tell, hinges on later     p/e to take Focus Media private, since its purchase
flipping Focus Media to a larger company. That's         mechanism will likely halve profits.
because the chances seem slight a privatized Focus
Media will be later approved for domestic Chinese        A typical LBO in the US relies on borrowed money
IPO. But, what if Focus turns out to be flip-proof?      to finance more than half the total acquisition cost.
                                                         The more Focus Media borrows, the bigger the hit
With so much money -- as so many big name PE             to its net income. Now, sure, the investors can
firms' reputations -- on the line, you'd think there     argue Focus Media should later be valued not on
would a clear, persuasive investment case for this       net income, but on EBITDA. That's the way LBO
Focus Media deal. As far as I can tell, there isn't. I   deals tend to get valued in the US. EBITDA, though,
have the highest respect for the PE firms involved       is still something of an unknown classifier in China.
in this deal, for their financial and investing          There isn't even a proper, simple Chinese
acumen. They are the smartest and most                   translation for it. Separately, Focus Media is
experienced group of PE professionals ever               already carrying quite a bit of debt, equal to about
assembled to do a single Chinese deal. And yet,          60% of revenues. Adding another big chunk to
based on materials I've seen, I can't figure out         finance the buyout, at the very least, will create a
what they are thinking with this deal and while          very wobbly balance sheet. At worst, it will put real
they all want a piece of this action.                    pressure on Focus Media's operating business to
                                                         generate lots of additional cash to stay current on
If the goal is to try to arbitrage valuation             all that borrowing.
differences between the US and Chinese stock
markets, this deal isn't likely to pan out. It's not     I have no particular insight into Focus Media's
only that Focus Media will have a tough time             business model, other than to note that the
convincing China's securities regulator, the CSRC,       company is doing pretty well while already facing
to allow it to relist in China. Focus Media is now       intensified competition. Focus Media doesn't meet
trading on the NASDAQ at a trailing p/e multiple of      the usual criteria for a successful LBO deal, since it
18. That is not much lower than companies quoted         isn't a business that seems to need any major
in China.                                                restructuring, refocusing or realignment of
                                                         interests between owners and management.
Next problem, of course, is the impact on the P&L
from all the borrowing needed to complete the deal.      Focus Media gets much of its revenue and profit
There's been no clear statement yet about how            from installing and selling ads that appear on LCD
much equity the PE firms will commit, and how            flat-screens it hangs in places like elevators and
much they intend to borrow. To complete the              retail stores. It's a business tailor-made for
buyout, the investor group, including the PE firms       Chinese conditions. You won't find an advertising
along will need to buy about 65% of the Focus            company quite like it in the US or Europe. In a
equity. The other 35% is owned by Focus Media's          crowded country, in crowded urban shops, housing
chairman and China's large private conglomerate          blocks and office buildings, you can get an ad in
Fosun Group. They both back the LBO deal.                front of a goodly number of people in China while
                                                         they are riding up in a jammed elevator or waiting
So, the total check size to buy out all other public     at a checkout counter.
shareholders will be around $2.4 billion, assuming
they investor group doesn't need to up its offer. If     The overall fundamentals with Focus Media's
half is borrowed money, the interest expense             business are sound. The advertising industry in
would swallow up around 50% Focus Media's likely         China is growing. But, it's hard to see anything on
2012 net income. In other words, the LBO itself is       the horizon that will lift its current decent
going to take a huge chunk out of Focus Media's          operating performance to another level. Without
net income. Run the numbers and it looks like the        that, it gets much harder to justify this deal.
PE group is actually paying about twice the current

This is, it should be noted, the first big LBO ever    The risk is that neither of these two giants will
attempted by a Chinese company. It could be that       agree to pay a big price down the line for a
the PE firms involved want to get some knowledge       company that could buy now for much less. The
and experience in this realm, assuming that there      same logic applies to any other Chinese acquirer,
could be more Chinese LBOs in the future. Maybe.       though they are few and far between. I'd be
But, it looks like it could be pretty expensive        surprised if Tencent or Baidu hasn't already run the
tuition.                                               numbers, maybe at Focus Media's invitation. But,
                                                       they didn't make a move. Not up to now.
Assuming they can pull off the "delist" part of the
deal, the PE firms will need to find a way to exit     Could it be they don't want to do the buyout
from this investment sometime in the next three to     directly, out of fear it could go wrong or hurt their
five years. Focus Media's chairman has been vocal      PR? Maybe. But, I very much doubt they will be
in complaining about the low valuation US              very eager to play the final owner in a very public
investors are giving his company. In other words,      "greater fool" deal.
he believes the company's shares can be sold to
someone else, at some future date, at a far higher     I'm fully expecting to be proven wrong eventually
price. (He personally owns 17% of the equity.)         by this powerhouse group of PEs, and that they will
                                                       end up dividing a huge profit pile from this Focus
Who exactly, though, is this "someone else"?           Media LBO. If so, the last laugh is on me. But, as
Relisting Focus Media in China is a real long shot,    of now, the Focus Media deal's investment logic
and anyway, the current multiples, on a trailing       seems relatively weak.
basis, are comparable with NASDAQ's . This is
before calculating the hit Focus Media's earnings
will take from leveraging up the company with lots
of new debt. How about the Hong Kong Stock
Exchange? Focus Media would likely be given a
warm welcome to relist there. One problem: with                   Jiuding: Has Its
Hong Kong p/e multiples limping along at some of               Remarkable Success Run
the lowest levels in the world, the relisted Focus
Media's market value would almost certainly be                      Its Course?
lower than the current price in the US. Throw in, of
course, millions of dollars in legal fees on both      In China's PE jungle, a mouse is king. Started just
sides of the delist-relist, and this Hong Kong IPO     five years ago, Kunwu Jiuding Capital (昆吾九鼎投资
plan looks like a very elaborate way to park then      管理有限公) has probably achieved the best results
lose money.                                            and best returns for investors in China's private
                                                       equity industry over the last three years. Indeed,
That leaves M&A as the only viable option for the      few if any PE investors anywhere have out-
PE investor group to make some money. I'm              performed Jiuding in recent years.
guessing this is what they have on their minds, to
flip Focus Media to a larger Chinese acquirer. They    With only around $1 billion in assets, Jiuding is
may have already spoken to potential acquirers,        around 1%-2% the size of the leading global PE
maybe even talked price. The two most obvious          firms like Blackstone, KKR, Bain Capital and Carlyle.
acquirers, Tencent Holdings and Baidu, both may        Yet, none of these firms matches Jiuding's recent
be interested. Baidu has done some M&A lately,         record at investing, exiting, and pocketing big
including the purchase, at what looks to many to       returns in China. The firm is about as different
be a ridiculously high price, of a majority of         from the likes of TPG, KKR and Carlyle as firms in
Chinese online travel site Qunar. So far so good.      the same industry can get. Jiuding isn't staffed
                                                       with Ivy League MBAs, operates out of modest
                                                       offices, makes no claim to particular expertise in

business operations, nor does it reward its              The average hold time for other PE firms investing
partners with hundreds of millions in profits from       in China can be as long as six to eight years. These
carried interest.                                        other firms are willing to invest earlier and then
                                                         help the company transition, often over a two to
Jiuding has mastered a form of PE investing devoid       three year period, to full tax and regulatory
of glamour, prestige or deal-making genius. Rather       compliance. This is a prerequisite before filing for
than "Barbarians at the Gate", think more                IPO. Change in China is perpetual, sudden, frenetic.
"Accountants at the Cash Till". Jiuding may want to      The longer a PE firm holds an investment, the
savor its current status as "king of the China PE        greater the risk some change in the rules, or the
jungle". The money-making formula Jiuding has            domestic market, or the exchange rate, or the
used so effectively is getting tougher all the time.     competitive landscape will ruin a once-strong
The Jiuding investment method is blunt: it invests
only in Chinese companies it believes will very          These uncertainties, as well as the significant risk a
soon thereafter get approved for domestic IPO. It's      Chinese company will not pass CSRC's IPO
not trying to guess which industries will flourish, or   approval process, are the two largest China PE
how Chinese consumers will spend their money in          investment risks that Jiuding tries to eliminate. For
the future. It makes no bets on unproved                 Jiuding, this means a hyper-technical focus on
technologies, or companies that may be growing           whether a company is paying all its taxes and
fast, but are still years away from an IPO. Its          whether its main customer is actually the founder's
investment technique is based on reproducing             brother-in-law. In other words, are there serious
internally, as much as possible, the lengthy,            related party transactions? This is often the main
opaque approval IPO process of China's all-              reason the CSRC turns down an IPO application.
powerful securities regulator the CSRC.
                                                         Other PEs, particularly the global giants, take a
Jiuding focuses more on guessing what the CSRC           different approach. They expend huge energy on
will do, rather than how a particular company will       the process of analyzing and predicting the future
fare. This way, it hopes to capture a big valuation      course of a company's products, markets,
differential between its entry price and exit price      competitive position. This involves a lot of brain
after IPO. At its high point two years ago, there        power and also some guesswork. The results are
was a ten-fold gap between Jiuding's entry and           mixed. A lot of deals never close, because the PE
exit multiples. Jiuding bought in at a p/e of less       firm, after spending hundreds of thousands of
than 10X, and could exit at over 80X. Though             dollars and lots of man-hours, can't complete due
share prices and p/e multiples have fallen, the gap      diligence. Others will never reach the stage of even
remains ample, still under 10X going in, and a           applying for IPO, let alone getting approval.
likely 25X-30X going out.
                                                         Jiuding seems perfectly-adapted to the Chinese
Here's the way it works: the CSRC IPO approval           investment terrain. When its process works, its
process can take anywhere from two to five years.        bets pay off handsomely, often delivering returns
Jiuding times its investment as close as legally         of at least three times capital invested. Jiuding
permissible to the time when the company will file       calls this a "PE factory method". It tries to
for IPO. It then gets to work doing everything it        systematize as much of the investment process as
can to improve the likelihood of CSRC approval,          possible. Jiuding has a huge staff of at least 250
attending meetings at the CSRC, lobbying                 people, ten times the size of other PEs in China.
backstage. When things go smoothly, Jiuding can          They are kept busy doing this work of collecting
enter and exit an investment in three years,             company data and then simulating the CSRC's
including the mandatory one-year lockup after IPO.       approval process. It invites its LPs, mainly wealthy
                                                         Chinese bosses, to participate in deal screening
                                                         and approval. If the majority of LPs doesn't

approve of a deal, it doesn't get done. In the PE          Jiuding to get in and out of deals quickly, a key to
industry, this is often known as "letting the lunatics     its success. The backlog of Chinese companies with
run the asylum".                                           CSRC approval and waiting to IPO is now at around
                                                           500. In most cases, that means a wait of at least
To be sure, Jiuding doesn't always get it right. It        two years after the laborious CSRC process is
does more deals each year than just about every            complete. A lot can go wrong during that time. So,
other PE firm in China. Quite a few will flame out         an investor like Jiuding will need to understand,
before IPO. But, Jiuding will usually get its original     before going in, more about a company and its
investment back, by forcing companies to buy back          longer-term prospects.
the shares. Meantime, its IPO hit rate is high, as
far as I can tell. The company discloses                   In China's PE market, where good companies are
information only sporadically, and its website lists       plentiful and IPO exits are limited, Jiuding has
only fourteen IPOs. Its actual tally is certainly far      prospered by focusing more on understanding the
higher. Jiuding regards everything about its               regulator than on understanding a company's
business -- its portfolio of investments, its total        business model and industry. It never needed to
capital, its staff size -- as commercial secrets.          bother much with monitoring the day-to-day
                                                           dramas of running a company, or offering sage
Jiuding differs in another important way from              advice as a board member, or helping a company
larger, better-known PE firms: it helps itself to less     expand its partnerships and improve marketing.
of its LPs' money . Jiuding takes a lower                  Yet, all this is becoming more and more necessary.
management fee, usually a one-time 3% charge,              These aren't skills Jiuding has mastered. Who has?
rather than annual 1%-3%, and awards itself with           The same big global PE firms (including Carlyle,
a smaller carry on successful deals. Jiuding's             TPG, Blackstone, KKR, Bain Capital) that Jiuding
almost as efficient at raising money as it is              has lately run circles around. Jiuding's "PE factory"
investing it. It's already raised at least ten different   must adapt or die.
funds, including, recently, a dollar one.
With everything going so well, Jiuding, and its
stripped-down approach to PE investing, looks
unstoppable. But, there are some signs of serious           
problems ahead for Jiuding. Its main problems now
aren't raising money or even finding good                   
companies. Partly, it's a challenge familiar to most
successful Chinese companies, including many                
Jiuding has invested in: copycats start springing up
everywhere. In the last two years, hundreds of              
new Renminbi PE firms were founded. Many are
trying to duplicate Jiuding's formula. They also            
focus on companies ready to apply for IPO, and
also try to anticipate the way the CSRC will rule on        
the application. Jiuding needs to fight harder now
to win deals, and often does this by agreeing to            
invest at higher price than others. That will
inevitably lower potential returns.

The second, larger problem is the CSRC's IPO
approval process itself. It is becoming slower, and
also even more impenetrable and unpredictable,
even to the savants at Jiuding. It's harder now for                                                      


        The M&A Wakeup Call in                         This new-found sense of realism is probably what's
                                                       needed to jumpstart the M&A market in China.
               China                                   M&A valuations in China has tended to trail IPO
                                                       valuations rather substantially. That remains true.
                                                       Potential buyers we talk to now are looking to
Recent evidence in our work suggests that the          acquire companies for as little as three to four
                                                       times their this year's net income, about 80% less
long-predicted, but never-quite-materialized,
launch of large-scale domestic M&A activity in         than the same company might receive in an IPO
                                                       valuation, as well as perhaps 50% below the
China may be ready for take-off.
                                                       valuation a PE investor would give for a minority
While there are some good fundamental reasons
for M&A to flourish in China, particularly the
opportunities for consolidation in many industries,    In other words, in China, contrary to other places,
                                                       there seems now to be a "control discount" rather
the key fact propelling M&A activity now is sorry
                                                       than a "control premium" in M&A deals. There is no
state of the domestic capital market, and the slap-
in-the-face effect this is having on private           real reason or logic behind this. It simply reflects
                                                       the fact that acquirers believe they can negotiate a
company bosses. Valuations for quoted companies
                                                       lower price than a PE investor. While PE investors
have come down significantly, by around 30% to
50% from eighteen months ago. This, in turn, is        are many in China, companies with the cash and
                                                       appetite to do M&A deals are few.
pushing down the valuation of companies in
domestic M&A deals, making acquisitions more
attractive to prospective buyers. The other key        In the main, the most likely and most credible
factor is that the backlog of companies waiting for    acquirers in China are domestically-listed
IPO approval, and the odds of getting CSRC             companies. They are the only ones with the ready
approval. Both continue to grow longer. With each      cash to buy. Private companies in China can't
passing year, the percentage declines of private       easily do M&A deals. Banks won't provide
companies making it through the three-to-five year     acquisition finance. A selling company will usually
IPO approval process.                                  be loathe to accept as payment shares of an
                                                       illiquid acquirer.
Simply put, the exit math for private company
bosses in China has changed dramatically over the      In the last few months, public companies all seem
last 12 months. It's getting harder, in many cases     to be waking up to the fact that M&A is a great
impossible, to IPO. This leaves M&A as the only        way to boost profits and their share price. In just
other viable path to exit. But, the challenge to       about every scenario, as well as every deal we're
getting a deal done are both psychological and         involved in, any acquisition will be highly accretive
practical. First, owners must accept that valuations   to the buyer. That term, "accretive" doesn't
are way below where they hoped them to be, as          translate well into Chinese. But, the concept it
well as well below the level of just a year ago,       understood by everyone involved in domestic M&A
when they topped out at over 100 times last year's     in China. Stock market p/e multiples remain very
net income. Second, the number of companies            much higher than those put on M&A deals. A public
looking to sell is quickly beginning outnumber the     company that acquires a private company for four
qualified and capable acquirers. This will put         times this year's profits can consolidate the
further downward pressure on valuations.               acquired earnings, and, with a bit of luck, see the
                                                       stock market value those newly-acquired profits at
                                                       25 to 30 times. In most cases, the acquired
It boils down to a sobering message to business
                                                       company is growing faster, and has higher net
owners seeking exit through M&A: "You should
accept a cheaper price than you expected, and do       margins, than the acquirer.
so quickly, before valuations fall even further."

A publicly-traded company has the choice to use                    Private Equity Valuation:
its cash to finance its own organic growth. But, we
don't see a lot of enthusiasm for that. Without                     Terminal Multiple is All
necessarily doing all the rigorous financial                             That Matters
modeling, many bosses of public companies seem
to be persuaded it's easier, faster and less risky to
buy profits, through M&A, than to try to manu-           A lot gets written, and even more gets discussed,
facture them by investing in new factories or in-        about how to value private companies for the
house R&D.                                               purposes of PE or VC investment. There is a lot of
                                                         “Barbarian talk” going around, a translation of the
                                                         Chinese term, 胡说 , meaning senseless drivel. As
A complicating factor: stock market rules in China
                                                         an investment bank, we sit in the middle between
don't make it all that easy for publicly-traded
                                                         PE firms and companies, each with its own
companies to do M&A. In most cases, the acquiring
                                                         valuation method and expectations. PEs often use
company will need to get prior approval from the
                                                         misleading comps to justify a lowball valuation.
stock market regulator the CSRC, particularly if
                                                         Companies are no less guilty, setting their
they seek to pay using their shares. That approval
                                                         valuation expectations unrealistically high, based
is far from automatic. The CSRC does not evaluate
                                                         on hear-say about other deals being done or a
M&A deals based on their accretive value to public
                                                         misreading of current stock market p/e multiples.
shareholders. If they did, they'd give a speedy OK
to just about every deal they're asked to approve.       So, how do you work out a fair valuation? The only
Instead, the CSRC assesses a proposed deal based         way I know is if both sides agree on the same set
on industrial logic as well as its overall impact on     of facts to advance from. That is already challenge
the acquiring company's balance sheet.                   enough. How big a challenge?

If a potential acquirer recently went public in China,   Below, I share part of an email memo I sent to a
it made solemn pledges to the CSRC about how it          large Chinese industrial equipment manufacturer.
planned to use the IPO proceeds. In most cases,          It gives an insider look at the work an investment
the promised use-of-proceeds did not include doing       bank like ours must do in China. It includes
opportunistic M&A deals. That alone can be reason        explaining frankly why companies need to be more
for the CSRC to turn down an M&A deal. There are         realistic about the price they can get for their
ways around this, including different forms of           shares. This straight talk means we sometimes
"creeping takeover". But, M&A in China, when a           lose potential clients. Here's the background: the
public company is involved, will always involve          company's controlling shareholder wants to sell
levels of regulatory risk unseen in other markets of     part of their stake, while also raising some new
the world.                                               capital for the business. They are a sophisticated
                                                         group, with strong management. They approached
                                                         several investment banks, including ours, to
In our experience, when private company bosses
                                                         represent them in the capital raising. They chose
start negotiating with publicly-traded ones, they
                                                         CFC as one of two finalists. They then insisted
quickly come to see what a hassle it is to list on
                                                         that the advisor must achieve a valuation for them
the stock market. This creates another incentive to
                                                         of at least 10X this year’s net income.
sell out. An IPO brings status and a paper fortune.
It also traps a company and its boss in the world's      In more than just the two words “that’s
most convoluted securities regulatory system. The        unreasonable”, I tried to explain why this com-
boss of a public company must wait three years           pany needs to be more accommodating with reality.  
from an IPO to start cashing in his shares. In an
M&A deal, the selling boss gets cash on the day of       “Your goal, which I thoroughly share, is to bring in a 
closing, and if he so chooses, be relaxing in Macao
                                                         first‐rate PE and get the best price for a valuable asset. I 
                                                         would work with all my diligence to achieve that.  But, 
the day after.
                                                         let’s look frankly and factually at current market 
                                                         conditions. At the moment, domestically‐listed Chinese 

companies in [your]  industry are trading at a trailing         The ratchet trigger is very unfortunate for the company, 
p/e of 28X and forward (this year’s) p/e of 22x. Both           and reflects the fact they are badly advised, by advisory 
have fallen by approx. one‐third in the last year. (The         firms paid a fee based on “headline valuation at closing” 
22X is the basis we should use, to compare like‐with‐like.      not terminal valuation.   
You have set your valuation target of +10X based on this 
                                                                The other condition attached to deals with headline p/e 
year’s net income.)  
                                                                of +10X is a high IRR (usually +20% p.a. simple interest) 
Your valuation target of +10X is a discount to quoted           for buybacks triggered by “no qualifying IPO”. The 
comps of 50% or narrower. That is a smaller discount,           buyback is a feature of almost all PE deals done in China. 
and so higher entry valuation for PE firms, than deals          As you would be financially liable for such a payment, if 
being done now.                                                 I work as your investment banker, I’d want to negotiate 
                                                                this mechanism very carefully with PE, to assure your 
As you know, all PE deals, since they involve illiquid 
                                                                best interests are fully protected. It’ll mean a fight with 
companies often years away from IPO exit, are always 
                                                                the PE firms, but it will be gentlemanly. You want an 
done at discount to quoted comps. The discount is not 
                                                                IRR of no more than 10%. Why? One way to think of it is 
fixed, but the only time PE deals were closed routinely at 
                                                                that for every 100 basis points the buyout IRR is fixed 
prices over 10X (rarely if ever above 15X) was two years 
                                                                above LIBOR, you can argue the terminal multiple falls 
ago or more when comparable stock market p/e 
                                                                by 0.3X to 0.5X, because of the contingent liability.   
valuations (generally on the CHINEXT)  were 70X‐100X 
previous year’s net.   A rich price indeed, and for a while,    Yours is a highly cyclical industry. We are now in the 
it had a levitating effect on PE valuations.                    downward loop, heading for the bottom of cycle. This 
                                                                negatively impacts valuation. Your cap table, 
Current market conditions are that there are probably 
                                                                particularly the fact the company is controlled by a CEO 
no investments from first‐line PEs with terminal 
                                                                who has no capital directly invested in the business, also 
multiples at +10X. I emphasize the word “terminal 
                                                                negatively impacts valuation. For last three years (2009, 
multiple” because quite often — too often in our 
                                                                2010, 2011) your net income has been flat, and net 
experience — a PE will offer a higher multiple at term 
                                                                margins have fallen by almost half. This too negatively 
sheet stage, to win the competitive right to pursue 
                                                                impacts valuation.  That’s three strikes already. You’re 
exclusive due diligence. These deals are almost always 
                                                                not ”out”, as in baseball. But, it’s a three‐ton weight 
“repriced” at closing to a level below 10X, when PE firm 
                                                                pushing down your terminal multiple.   
has most of the leverage. PE will claim they turned up 
“new facts” in DD, as they always do, that justify the          I can promise you that if we work together, you will get 
repricing.  They promise you +10x in a term sheet               the best outcome available in current marketplace, and 
knowing they will only close the deal at a lower price,         be working with a firm that shares your commitment to 
when all other interested investors have vanished from          integrity, professionalism and accountability.   
the scene. Unfair? Duplicitous? Get used to it. It’s the 
                                                                But, if you do decide to move forward with the other 
way the game is played.  
                                                                advisor, I’d urge you to ask them to address the specific 
The other common occurrence in China PE is that there           points raised here, and structure their compensation on 
is a headline multiple of +10X but it is linked to an           an “all or nothing” basis: they only earn a fee if the 
aggressive next year + this year (sometime even three           terminal multiple is above 10X, as they are now 
year) profit guarantee. The level is set by PE firm in full     promising.   
expectation that company will not meet the profit 
                                                                A seller’s focus on valuation is understandable. But, too 
targets, so triggering the ratchet, often quite punitive. 
                                                                often in our experience, it can play into the hands 
This process will bring the terminal multiple down 
                                                                of both the PE investor and your investment banker. 
significantly. We’ve seen and heard of deals where this 
                                                                Both will encourage your expectations knowing that the 
terminal multiple is half the headline number at signing 
                                                                final bill on valuation will only be presented to you in 
of term sheet or Share Purchase Agreement. In other 
                                                                two to three year’s time. More often than not, only they 
words, the SPA has a headline multiple of 12X, 
                                                                will be feeling victorious at that point. 
but terminal multiple, after ratchet is triggered,  works 
out to 6X‐7X.                                                   Cordially, 
From my experience, the ratchet is triggered in over half 
PE deals done in China. In the case of some leading             This company decided to retain the other
China PEs, [names omitted to shield the guilty], the            investment bank.
ratchet is triggered in over 80% of the deals they do.           


        The Value of Government                         Let's look at China. Buying off politicians is less
                                                        visible, and outcomes are different, than in the US.
            Support in China                            China's tax code is not the unwieldy monster it is
                                                        in the US. It isn't the product, as America's is, of
All governments favor local businesses. Some do         an anybody-want-to-buy-a-taxbreak system. In
it better than others. China is among the best. The     the US, General Electric can get away with paying
system of government support in China is more           no corporate income tax despite billions in profits
extensive, more fair and less prone to corruption       because it's very good at working the system and
than elsewhere. Surprised? Many will be, since          buying the favors required to create tailor-made
many people operate on the false, though                tax loopholes. Big companies in China, especially
comforting, assumption that everything Chinese          SOEs, do get special favors, but not special deals
officials do is the result of bribe-taking.             written into tax code. China's government tends to
                                                        be relaxed in its role as controlling shareholder. It
The thing about corruption is, most of it,              seldom demands an SOE turn over a large
everywhere, is hidden from view. There is no real       percentage of its after-profits in the form of
empirical basis to assess which countries have the      dividends.
highest corruption. Instead, everyone tends to fall
back on the "Corruption Perceptions Index" reports      Where China's system of political favors works
generated by a group called Transparency                better than elsewhere is in spreading the perks far
International. It does what it can to measure the       more widely and equitably. So, both state-owned
un-measursable. Its results get skewed by relying       giants and small entrepreneurial companies can
rather heavily on Western businessmen's own             both benefit. In the US, Europe or Japan, the
perceptions about where bribery is most rampant.        system of political favors is "pay to play" . In China,
For many of these people, China fits the Western        it's more a matter of maintaining a modest level of
stereotype of a country whose officialdom seems         employment (probably above about 50 workers)
rotten from top to bottom.                              and paying at least some of the taxes you
                                                        nominally owe. Do that and the government will
The reality is rather different. I'm not prepared to    usually make available a wide assortment of grants
argue China doesn't have a corruption problem. It       and benefits, from land at low concessionary prices,
manifestly does. The country's own leadership is        to investment credits and tax holidays to free
frequently heard denouncing the problem. My point       infrastructure upgrades.
here is to discuss the productive, above-board and
even-handed ways government in China, at every          Again, what is most notable, and commendable,
level, provides useful and valuable support to          about the system of political favors in China is how
companies. Here, the comparison with the US is          much more inclusive it is. You don't need to pay off
very stark indeed. Government favors in the US          a local official, or put his kid through college in the
are mainly, and explicitly, sold to the highest         US. That sort of stuff may happen, and may for all
bidder. It's what drives much of the billions of        I know bring even larger benefits. But, a payoff is
dollars "invested" every year by companies, unions,     not a prerequisite for a government favor or
lobbyists and individuals in political campaigns.       handout. In fact, the most valuable forms of
You help a politician win, and he helps you then        government support I've heard of go to companies
get a tax-break, a loophole, a sweetheart               that successfully IPO. Nothing else. They don't
government contract, a regulatory exemption, an         need to take government contracts or employ the
R&D grant, a zoning change, a loan guarantee.           mayor's nephew. Companies are rewarded by the
                                                        government for going public -- which, by the way,
In the US, the system of favors-for-money is so         given high IPO multiples in China, is enough of a
widespread, so deeply woven in the grain of the         reward in itself.
political system, that Americans don't even bother
to talk about it much. It's as American as apple pie.

These newly-public companies are often, if not            The land-for-IPO deals are a very small part of a
always, sold a piece of land to build a new               very large whole, making up the totality of
headquarters on. The price of that land will almost       government favors and support available to
certainly be sold to the newly cash-rich IPO              businesses in China. The government in China has
company for a fraction of its market value. I've          far more power and far more wealth at its disposal
also seen cases where a local government gives a          than anywhere else I've lived and worked. In other
plot of land, at a very low price, to a local company     words, it has complete discretion, as well as more
that successfully raises PE.                              prizes to dole out. The remarkable thing is how
                                                          evenly they do try to spread their help around.
A case of rich getting richer? Perhaps. But, note,
this valuable land is not sold to the highest bidder,     In the US, a small businessman is told by the
or the guy offering the valise filled with                current President he is a "millionaire and
untraceable $100 bills. It is a reward for                billionaire", and should pay half his annual income
achievement, not a backhander. I prefer this kind         in taxes, with little special in return. The same
of politician-to-businessman transaction to what          scale businessman in China pays less punitive
routinely goes in the US, or UK, where political          rates and is rewarded by government with favors
parties, in return for donations, sold knighthoods        that help his business grow, and his profit margins
and other titles.                                         increase. If this is corruption, give me more!

                                                                                             --- Peter Fuhrman

                                        © CHINA FIRST CAPITAL

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