VIEWS: 9 PAGES: 16 CATEGORY: Corporate Finance POSTED ON: 9/30/2012
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
Private Equity in China 2012 The Pace of Change Quickens INSIDE THIS REPORT: Dollars No Longer Welcome Cornerstone Investing 2 4 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 2 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 3 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 profit. 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 4 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- 5 How Valuation Arbitrage Can Misprice Chinese Investments 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 6 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 7 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 8 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 9 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 company. 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 10 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 11 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 stake. 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." 12 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 13 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, Peter” 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. 14 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. 15 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 Chairman © CHINA FIRST CAPITAL Tel: 0755 86590540 Email: firstname.lastname@example.org Website: www.chinafirstcapital.com 16
"PE in China 2012-2013 The Pace of Change Accelerates"