Private Equity in China 2012 - 2013 Positive Trends & Growing Challenges

INSIDE THIS REPORT:

Too Few Exits: Core Challenge for PE in China From IPO to IRR: PE's Changing Game-plan RMB Funds New Model The OTCBB-Ization of HKSE The CSRC Disciplines IPO Process China's SOEs Transform Xinjiang Rewrites China's Energy Policy China's Huge Unknown Entrepreneur 2 4 6 8 10 11 13 15

Too Few Exits The Core Challenge Facing Private Equity in China
The amount of capital going into private equity in
China continues to surge, with over $30 billion in new capital raised in 2011. The number of private equity deals in China is also growing quickly. More money in, however, does not necessarily mean more money will come out through IPOs or other exits. In fact, on the exit side of the ledger, there is no real growth, instead probably a slight decline, as the number of domestic IPOs in China stays constant, and offshore IPOs (most notably in Hong Kong and USA) is trending down. M&A activity, the other main source of exit for PE investors, remains small in China. This poses the most important challenge to the long-term prospects for the private equity industry in China. The more capital that floods in, the larger the backlog grows of deals waiting for exit. This imbalance is going to become a key fact of life, and ultimately a big impediment, to the continued expansion of capital raised for investing in China.

Heres a way to understand the problem: there is probably now over $50 billion in private equity capital invested in Chinese private companies, with another $50 billion at least in capital raised but not yet committed. That is enough to finance investment in around 6,500 Chinese companies, since average investment size remains around $15mn. At the moment, only about 250 Chinese private companies go public each year domestically. The reason is that the Chinese securities regulator, the CSRC, keeps tight control on the supply of new issues. Their goal is to keep the supply at a level that will not impact overall stock market valuations. Getting CSRC approval for an IPO is becoming more and more like the camel passing through the eye of a needle. Hundreds of companies are waiting for approval, and many hundreds more will likely join the queue each year by submitting IPO applications to the CSRC. Is it possible the CSRC could increase the number of IPOs of private companies? In theory, yes. But, there is no sign of that happening, especially with the stock markets now trading significantly below their all-time highs. The CSRCs primary role is to assure the stability of Chinas capital markets, not


to provide a transparent and efficient mechanism for qualified firms to raise money from the stock market. Coinciding now with the growing backlog of companies waiting for domestic IPOs, offshore stock markets are becoming less and less hospitable for Chinese companies. In Hong Kong, its generally only bigger Chinese companies, with offshore shareholder structure and annual net profits of at least USD$25 million, that are most welcome. In the US, most Chinese companies now have no possibility to go public. There is little to no investor interest. As the Wall Street Journal aptly puts it, Investors have lost billions of dollars over the last year on Chinese reverse mergers, after some of the companies were accused of accounting fraud and exaggerating the quality and size of their assets. Shares of other Chinese companies that went public in the United States through the conventional initial public stock offering process have also been punished out of fear that the problem could be more widespread. Other minor stock markets still actively beckon Chinese companies to list there, including Korea, Singapore, Australia. Their problem is very low IPO price-earnings valuations, often in single digits, as low as one-tenth the level in China. As a result, IPOs in these markets are the choice for Chinese companies that truly have no other option. That creates a negative selection bias. Bad Chinese companies go where good companies dare not tread. For the time being, LPs still seem willing to pour money into funds investing in China, ignoring or downplaying the issue of how and when investments made with their money will become liquid. PE firms certainly are aware of this issue. They structure their investment deals in China with a put clause that lets them exit, in most cases, by selling their shares back to the company after a certain number of years, at a guaranteed annual IRR, usually 15%-25%. Thats fine, but if, as seems likely, more and more Chinese investments exit through this route, because the statistical likelihood of an IPO continues to decline, it will drag down PE firms overall investment performance. Until recently, the best-performing PE firms active in China could achieve annual IRRs of over 50%. Such returns have made it easy for the top firms like CDH, SAIF, New Horizon, and Hony to raise money. But, it may prove difficult for these firms to do as well with new money as they did with the old. These good firms generally have the highest success rates in getting their deals approved for domestic IPO. That will likely continue. But, with so many more deals being done, both by these good firms as well as the hundreds of other newlyestablished Renminbi firms, the percentage of IPO exits for even the best PE firms seems certain to decline. The assumption is exits through M&A will increase significantly. After all, this is now the main exit route for PE and VC deals done in the US and Europe. But, there are significant obstacles to taking the M&A exit route in China, from a shortage of domestic buyers with cash or shares to use as currency, to regulatory issues, and above all the fact many of the best private companies in China are founded, run and majority-owned by a single highly-talented entrepreneur. If he or she sells out in M&A deal, the new owners will have a very hard time doing as well as the old owners did. So, even where there are willing sellers, the number of interested buyers in an M&A deal will always be few. Measured by new capital raised and investment results achieved, Chinas private equity industry has grown a position of global leadership in less than a decade. There is still no shortage of great companies eager for capital, and willing to sell shares at prices highly appealing to PE investors. But, unless something is done to increase significantly the number of PE exits every year, the PE industry in China must eventually contract. That will have very broad consequences not just for Chinese entrepreneurs eager for expansion capital and liquidity for their shares, but also for hundreds of millions of Chinese, Americans and Europeans whose pension funds have money now invested in Chinese PE. Their retirements will


be a little less comfortable if, as seems likely, a diminishing number of the investments made in Chinese companies have a big IPO payday. the percentage of deals achieving a domestic IPO in China may not reach 10%. If so, overall returns for each PE firm, as well as the industry as a whole, will fall rather dramatically from the high levels of recent years. The returns for most PE and VC firms across the world tend toward bell curve distribution, with a small number of highly successful deals more than covering losses at the deals gone sour, and the majority of deals achieving modest increases or declines. In China, however, the successful deals have tended to be both more numerous and more profitable. This has provided most of the propulsive thrust for the high rates of return. The higher the rate of return, the easier it is to raise new money. PE firms each year keep 1% to 2% of the money they raise every year as a management fee. Its a kind of tithe paid by LPs. PE firms also usually keep 20% of the net investment profits. But, this management fee is risk-free, and usually is enough to fully pay for the PE and VC firms salaries, offices, travel and other operating expenses, with anything left over split among the partners. So, high rates of investment return in the past ends up translating into lots of new money unlinked to actual investment performance in the future. Its a neat trick, and explains why the PE partners currently most actively out raising capital are mainly those investing in China. The more you raise now, the longer your guaranteed years of the good life. In other words, even if overall investment results deteriorate in coming years, the guaranteed income of PE firms will remain strong. Most funds have a planned lifespan of seven to ten years. So, if you raise $1 billion in 2012, you will have perhaps $20mn a year in guaranteed management fee income all the way through 2022. The more new capital thats raised for PE deals in China, the more investment deals can get done. The problem is, IPOs in China are basically a fixed commodity, with about 250 private companies going public a year. These domestic Chinese IPOs are the common thread linking most of the highest return PE deals. The Chinese IPOs will continue,

From IPO to IRR: The Changing Return Formula in Chinese Private Equity
Most investors would be delighted to make 15%
to 20% per year, year after year. But, for many private equity firms active in China, that kind of return would be cause for shame. The reason is that recent past returns from Chinese PE , and so the expectations of LPs, is much higher, often overall annual increases of 40%-60% a year, with successful individual deals increasing by 100% a year in value during a typical three to five year holding period. But, it is quickly becoming much more challenging to earn those +40% annual rates of return. My prediction is that profits from PE investing in China will soon begin a rather steep downward slide. This isnt because there are fewer good Chinese companies to invest, or that valuations are rising sharply. Neither is true. Its simply that a declining percentage of PE deals done in China will achieve those exceptionally high profits of 500%-800% or more over the life of an investment. The reason is that fewer and fewer PE deals in China will achieve exit through IPO. Those are the deals where the big money is made. There are no precise numbers. But, my estimate would be that in recent years, one in four PE investments made by the top 50 firms active in China managed to have an IPO. Those are the deals with the outsized rates of return that do so much to lift a PE firms overall IRR. In the future, the rate of successful IPO exit may fall by 30% or more for the good firms. For lesser PE firms, including many of the hundreds of Renminbi firms set up over the last three years,


and most likely continue to provide some of the highest profits available to PE firms anywhere. But, with the number of IPOs static and overall PE investment surging, the odds of a PE-backed company in China getting the green light for IPO will drop rather precipitously if the current gusher of new money for PE deals in China persists. Meantime, the number of Chinese companies going public outside China is dropping and will likely continue to. The US has all but barred the door to Chinese companies, following a spate of stories in 2011 about fraudulent accounting and false disclosure by Chinese companies quoted there. In Hong Kong, the only Chinese companies generating investor enthusiasm at IPO are ones with both significant size (profits of at least USD$25mn) and an offshore legal corporate structure. It used to be both simple and common for Chinese companies to set up holding companies outside China. The Chinese government has moved aggressively to shut down that practice, beginning in 2006. So, the number of private Chinese companies with the legal structure permitting a Hong Kong (or US, Singapore, Korean, Australian) IPO will continue to shrink. Add it up and the return numbers for PE firms active in China begin to look much less rosy going forward than they have in the past. More deals will end in mandatory buybacks, rather than IPOs. This is the escape mechanism written into just about every PE investment contract. It allows the PE firm to sell their shares back to the company if an IPO doesnt take place within a specified period of time, typically three to five years. The PE gets its original investment back, plus an annual rate of return (IRR), usually 10% to 20%. This way PE firms cant get stuck in an illiquid investment. The buybacks should become an increasingly common exit route for PE deals in China. But, they only work when the company can come up with the cash to buy the PE shares back. That will not always be certain, since pooling large sums of money to pay off an old investor is hardly the best use of corporate capital. Fighting it out in court will likely be a fraught process for both sides. The direction of Chinese PE is moving from IPO to IRR. As this process unfolds, and PE returns in China begin to trend downward, the PE investment process and valuations are likely to change, most likely for the worse. IRR deals seldom make anyone happynot the PE firms, their LPs or the entrepreneur. Chinese PE still offers some of the best riskadjusted returns of any investment class. But, as often happens, the outsized returns of recent years attracts a glut of new money, leading to an eventual decline in overall profits. In investing, big success today often breeds mediocrity tomorrow.

Renminbi Funds Seek to Rewrite the Rules of Profitable Investing

Renminbi private equity funds are the worlds
fastest-growing major pool of discretionary investment funds, with over $20 billion raised in 2011. These Renminbi funds also play an increasingly vital role in allocating capital to Chinas best entrepreneurial companies. Despite their size and importance, these Renminbi funds often have a structural defect that may limit their future success. Most Renminbi funds are managed by people whose pay is only loosely linked, if at all, to their performance. They are structured, typically, much like a Chinese state-owned enterprise (SOE), with multiple managerial levels, slow and diffuse decision-making, rigid hierarchies and little individual responsibility or accountability. The resemblance to SOEs is not accidental. Renminbi funds raise a lot of their money from state-owned companies, and many fund managers come from SOE background. Maximizing profits is generally not the prime goal of SOEs. They provide employment, steer resources to industries favored by government plans and policies. A similar mindset informs the way many Renminbi funds operate. Individual greed along with individual initiative are discouraged. There are no big pay-outs to partners. In fact, in most cases, there are no partners whatsoever. This represents a significant departure from the partnership structure of private equity and venture capital firms elsewhere. Partnership structure matters because it efficiently harnesses the greed of the people doing the investing. The General Partners (GPs) usually put a significant percentage of their own money into deals alongside that of the Limited Partners who capital they invest. GPs are also highly incentivized to earn profits for these LPs. The usual split is 1:4,

meaning the GP keeps 20% of net profits earned investing LPs money. Of course, partnership structure doesnt guarantee GPs are going to do smart things with LPs money. Theres lot of examples to the contrary. But, the partnership structure does seem to work better for both sides than any other form of business combination. GPs and LPs both know that the more the GP makes for himself, the more he makes for investors. Renminbi funds, in most all cases, are structured like ordinary investment companies, or as subsidiaries of larger state-owned financial holding companies. Instead of partners, they have large management teams and board of directors. The top people at Renminbi funds are picked as much for their political connections, and ability to source investment capital from government bureaus and SOEs, as their investing acumen. They are wage slaves, albeit well-paid ones by Chinese standards. But, their compensation might not even be 5% of what a partner at a dollar-based private equity firm can earn in a good year. A Renminbi fund manager will rarely have his own capital locked up alongside investors, and even more rarely be awarded that handsome share of net profits. Renminbi fund differ in other key ways from PE and VC partnerships. The Renminbi funds usually have relatively flat pay scales, modest bonuses and a consensus approach with often as many as 20 or more staff members deciding on which deals to do. A typical dollar-based PE fund in China might have a total of 15 people, including secretaries. A Renminbi fund? Teams of over 100 are not all that uncommon. A dollar PE firm investing billions may have an investment committee of as few as five people. Partners decide which deals to do. A Renminbi firm will often have ICs with dozens of members, and even then, their decisions are often not final. Often Renminbi funds need to get investors approval for each individual deal they seek to do. They dont have discretionary power, as PE partnerships do, over their investors money.


Renminbi funds have abundant manpower to scout for deals across all of China, and can throw a lot of people into the deal-screening and due diligence process. This bulk approach has its advantages. It can sometimes take a few months of on-the-spot paper-pushing, coaching and reorganizing to get a Chinese private company into compliance with the legal and accounting rules required for outside investment. Dollar funds dont have that capacity, in most cases. Also, Renminbi fund managers often have similar backgrounds to the middle management teams at private companies. They are comfortable with all the dining, wining, smoking and karaoke-ing that play such a core part of Chinese business life. The dollar funds? From partners on down, they are staffed by Chinese with elite educations, often including stints in the US working or studying. Usually they dont drink or smoke, and prefer to get back to the hotel early at night to churn through the target companys profit forecast. Kill-joys though they may be, the PE dollar funds still have, in my experience, some large and most likely decisive advantages over the Renminbi funds. Decision-making is nimble, transparent and centralized in the hands of the firms few partners. If they like a deal, they can issue a term sheet the same day. At a Renminbi fund, it can take months of internal meetings, report-writing and committee assessments before any kind of term sheet is prepared. Its often futile to try to figure out who really calls the shots at a Renminbi fund. Private company bosses, including several of our clients, are often loath to work with organizations structured in this way. The boss at one of our clients recently chose to take money from two dollar PE firms because he couldnt get a meeting with the boss of the wellknown Renminbi fund that was courting him hard. That firm compounded things by explaining the funds boss was anyway not really involved in investment decision-making and would certainly not join our clients board. The message this sent: nobody is really in charge, so if we invest, you are on your own. For a lot of Chinas self-made entrepreneurs, this isnt the sort of message they want to hear from an investor. They like dealing with partners who have decisionmaking power, their own money at stake alongside the entrepreneurs. PE partners almost always take a personal role in an investment by joining the board. In short, the PE partner acts like a shareholder because he is one, directly and indirectly. At a Renminbi fund, the managers do not have skin in the game, nor a clear financial reward from making a successful investment. A Renminbi fund manager can be fired or marginalized by his bosses at any time during the long period (generally at least 3-5 years) from investment to exit. Private equity investing has long time horizon, and the partnership structure is probably the best way to keep everyone (GP, LP, entrepreneur) engaged, aligned and committed to the long-term success of a company. It is possible for Renminbi funds to organize themselves as partnerships. But, few have done so, and its unlikely many will. The GP/LP structure is supremely hard to implement in China. Those with the money generally dont accept the principle of giving managers discretionary power to invest, and also dont like the idea of those managers making a significant sum from deals they do. All signs are that Renminbi funds will continue to grow strongly in number and capital raised. This is, overall, highly positive for entrepreneurship in China. Hundreds of billions of Renminbi equity capital is now available to private companies. As recently as three years ago, there was hardly any. Less clear, however, is how efficiently that money will be invested. I know from experience that Renminbi funds find and invest in great companies. But, they also are prone to a range of inefficiencies, from bureaucratic decision-making to a lack of real accountability among those investing the money, that can adversely impact their overall performance. One way or the other, Renminbi funds will rewrite the rules for private equity investing, and eventually provide a huge amount of data on how


well these managers can do compared to PE partners. Our guess is that Renminbi firms will not achieve as high a return as dollar-based PE firms investing in China. The reason is simple: investing absent of greed is often investing absent of profit. ICBC, CIIC, andBank of China. The assumption among many market players was that the HKSEs growth would continue to surge, thanks largely to Chinese listings, for years to come. With the US, Europe and Japan all in the economic and capital market doldrums, the investment banking flotilla came sailing into Hong Kong. Champagne corks popped. High-end Hong Kong property prices, already crazily out of synch with local buying power, climbed still higher. The underwriting business relies rather heavily on hype and boundless optimism to sell new securities. Its little surprise, then, that IPO investment bankers should be prone to some irrational exuberance when it comes to evaluating their own career prospects. The grimmer reality was always starkly clear. For fundamental reasons visible to all but ignored by many, the flood of quality Chinese IPOs in Hong Kong was always certain to dry up. It has already begun to do so. In 2006, the Chinese government closed the legal loophole that allowed many PRC companies to redomicile in Hong Kong, BVI or Cayman Islands. This, in turn, let them pursue IPOs outside China, principally in the US and Hong Kong. Every year, the number of PRC companies with this offshore structure and the scale and growth to qualify for an IPO in Hong Kong continues to decline. A domestic Chinese company cannot, in broad terms, have an IPO outside China. Some clever lawyers came up with some legal fixes, including a legally-dubious structure called Variable Interest Entity, or VIE, to allow domestic Chinese companies to list abroad. But, last year, the Chinese Ministry of Commerce began moving to shut these down. The efficient, high-priced IPO machine for listing Chinese companies in Hong Kong is slowly, but surely, being starved of its fuel: good Chinese private companies, attractive to investors. Yes, there still are non-Chinese companies like Italys Prada, Russias Rusal or MongoliasErdenes Tavan Tolgoi still eager to list in Hong Kong. There is still a lot of capital, while listing and compliance costs are well below those in the US. But, the Hong Kong underwriting industry is staffed-up mainly to

The OTCBB-ization of the Hong Kong Stock Exchange

From the worlds leading IPO stock market to a
grubby financial backwater with the sordid practices of Americas notorious OTCBB. Is this whats to become of the Hong Kong Stock Exchange ? We see some rather disturbing signs of this happening. Underwriters, with the pipeline of viable IPO deals drying up, are fanning out across China searching for mandates and making promises every bit as mendacious and self-serving as the rogues who steered so many Chinese companies to their doom on the US OTCBB. The Hong Kong Stock Exchange (HKSE) may be going wrong because so much, until recently, was going right. Thanks largely to a flood of IPO offerings by large Chinese companies, the HKSE overtook New York in 2009 to become the top capital market for new flotations. While the IPO markets turned sharply downward last year, and the amount of IPO capital raised in Hong Kong fell by half, the HKSE held onto the top spot in 2011. US IPO activity remains subdued, in part due to regulatory burdens and compliance costs heaped onto the IPO process in the US over the last decade. During the boom years beginning around 2007, all underwriting firms bulked up by adding expensive staff in expensive Hong Kong. This includes global giants like Goldman Sachs, Citibank and Morgan Stanley, smaller Asian and European firms like DBS, Nomura, BNP Paribasand Deutsche Bank and the broking arms of giant Chinese financial firms CITIC,


do Chinese IPOs. These guys dont speak Russian or Mongolian. So, the sorry situation today is that Hong Kong underwriters are overstuffed with overhead for a coming boom of Chinese IPOs that will almost certainly never arrive. China-focused Hong Kong investment bankers are beginning to show signs of growing desperation. Their jobs depend on winning mandates, as well as closing IPOs. To get business, the underwriters are resorting, at least in some cases, to behaviors that seem not that different from the corrupt world of OTCBB listing. This means making some patently false promises to Chinese companies about valuation levels they could achieve in an Hong Kong IPO. The reality now is that valuation levels for most of the Chinese companies legally structured for IPO in Hong Kong are pathetically low. Valuations keep getting slashed to attract investors who still arent showing much interest. Underwriters are finding it hard to solicit buy offers for good Chinese companies at prices of six to eight times this years earnings. Some other deals now in the market and nowhere near close are being priced below four times this years net income. At those kind of prices, a HK IPO becomes some of the most expensive equity capital around. In their pursuit of new mandates, however, these Hong Kong underwriters will rarely share this information with Chinese bosses. Instead, they bring with them handsomely-bound bilingual IPO prospectuses for past deals and suggest that valuation levels will go back into double digits in the second half of this year. In other words, the pitch is, dont look at todays reality, focus instead at yesterdays outcomes and my rosy forecast about tomorrows. This is the same script used by the advisors who peddled the OTCBB listings that damaged or destroyed so many Chinese companies over the last five years. Another similar tactic used both by OTCBB rogues and HK underwriters is to pray on fear. They suggest to Chinese bosses that they should protect their fortune by listing their company offshore, at whatever price possible and using whatever legally dubious method is available. They also play up the fact a Chinese company theoretically can go public in Hong Kong whenever it likes, rather than wait in an IPO queue of uncertain length and duration, as is true in China. In other words, the discussion concerns just about everything of importance except the fact that valuation levels in Hong Kong are awful, and there is a decent probability a Chinese companys HK IPO will fail. This is particularly the case for Chinese companies with less than USD$25 million in net income. The cost to a Chinese company of a failed IPO is a lot of wasted time, at least a million dollars in legal and accounting bills as well as a stained reputation. There is, increasingly, a negative selection bias. Investors rightly wonder about the quality of Chinese companies, particularly smaller ones, being brought to market by underwriters in Hong Kong. No one has a crystal ball, is how one Hong Kong underwriter, a managing director who spends most of his time in China scouring for mandates, explains the big gap between promises made to Chinese bosses, and the sad reality that many then encounter. In a real sense, this is on par with him saying Ive got to do whatever Ive got to do to earn a living. He can hold onto his job for now by bringing in new mandates, then hope markets will turn around at some point, the valuation tide will rise, and these boats will lift. This too is a business strategy used for many years by the OTCBB advisor crowd. The OTCBB racket is now basically shut down. Those who profited from it are now looking for work or looking elsewhere for victims, er mandates. Tiny cleantech deals are apparently now hot. Our prediction is a similar retrenchment is on the way in Hong Kong, only this time those being retrenched wont be fast-buck types from law firms and tiny OTCBB investment banks no one has heard of. Instead, itll be bankers with big salaries working at well-known brokerage companies. The pool of IPO fees isnt big enough to feed them all now. And, that pool is likely going to evaporate further, as fewer Chinese companies sign on for Hong Kong listings and successfully close deals.

The CSRC Disciplines the IPO Process in China

By turns mysterious, unpredictable, overextended
yet under-experienced, byzantine in its complexity and frustrating for all who deal with it, the CSRC () comes in for a lot of criticism. The Chinese stock market regulator makes and enforces the rules for all 3,200 public companies traded on the Shanghai and Shenzhen stock exchanges. Though modeled after the US SEC, the CSRCs remit is far broader. It alone decides which companies will be allowed to IPO. It plays gatekeeper, not just referee. To win CSRC approval, it is by no means enough, as it usually is in the US, to have an underwriter and a few years of audited financials. All of the seven hundred IPO aspirants waiting in the queue for CSRC approval have these. Only a small minority will manage to jump through all the CSRC hoops and win approval for an IPO. The CSRC makes its own judgment about a companys business model, future prospects, management caliber, shareholder structure, customer concentration, competitive position,planned use of IPO proceeds, the cleanliness of any outside investors money, related-party transactions, the appropriate IPO valuation, even the marital status of a companys founder. In effect, the CSRC is doing its utmost to take the caveat out of caveat emptor, by detecting ahead of time any taint that could damage a companys post-IPO process. The CSRC can of its own volition forbid companies in an industry to IPO, as it did recently with real estate developers and private steel companies. The purpose is to starve them of capital. It can also, just as suddenly, reverse its prior course and allow once-blacklisted industries to access public markets. It seems to be doing this now with Chinese companies in the restaurant industry. It can also play favorites. Companies from Chinas restive Xinjiang region are currently given special priority, and shown more leniency, in approving IPOs.

The CSRCs approach to IPO screening is not dissimilar to the way Goldman Sachs chooses companies to underwrite. Each is trying to select sure bets, companies that wont prove an embarrassment a few years down the road. Goldman does it to make money and keep its high reputation, the CSRC to avoid social upheaval. Keeping Chinas stock markets scandal free is a matter of paramount national importance. So far, the CSRC has succeeded at this. Accounting and disclosure scandals have become commonplace for Chinese companies quoted in Hong Kong and the US. Not in China. Credit the CSRCs thorough IPO filtering. The CSRC also keeps a tight lid on the supply of IPOs each year to prevent new issues from weighing down overall market valuation. There is another overlooked benefit to the CSRCs stringent IPO approval process. It weeds out the flim-flammery, hype and exaggerated salesmanship from the IPO process. Any company approved by the CSRC for an IPO is all but guaranteed a successful closing. The underwriters have it easy. They barely need to break a sweat. The same is most definitely not the case in the US and Hong Kong, for example. There, regulatory approval is the first and simplest step in an expensive, tightly-choreographed, quite often unsuccessful effort by underwriters to drum up investor interest and get them to bite. It involves a fair bit of hucksterism. In the US, IPO underwriters are salespeople. In China, they are order-takers. Chinese underwriters have limited discretion over IPO pricing. For one thing, the CSRC is watching, and can deal severely with underwriters who seek what the CSRC decides are overpriced valuations. It seems like everyone in China knows where IPO valuation multiples are at any given time. At the moment, they are around 35 times last years net income for smaller companies listing on the Chinext, and around 25 times for larger companies. The CSRC has grown increasingly vocal in criticizing big first day gains for newlyIPOd companies.

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The CSRC does not approve IPO applications of companies that dont have at least two years of profits or ones that have huge numbers of users, but comparatively light profits. That is to say, no Facebook, Groupon or Linkedin types are allowed. This, too, removes a lot of the investment banking sales wizardry seen in the US during the IPO process. One positive result of this is that underwriters in China are limited in what they can promise companies to win an IPO mandate. Good, bad or indifferent, an underwriter is likely to get just about the same price for shares it sells in an IPO. So, basically, winning mandates in China comes down to a lot of wining and dining, Karaoke and cartons of expensive cigarettes. Since the CSRCs approval process can drag on for up to two to three years, underwriters also have little, to no, say over IPO timing. The risk in the IPO process in China is, overwhelmingly, the risk of rejection by the CSRC. The CSRC rules mean underwriters and company are in it together. The underwriter needs to be active throughout the long process, and present at many meetings with the CSRC. The underwriters put their neck on the line by providing guarantees to the CSRC on the soundness of a companys financials and pre-IPO disclosure. Having seen the process from both angles, ten years ago as CEO of a US company during part of its IPO process, and now in China, working with clients seeking CSRC approval, my view is that the CSRCs method has a lot to recommend itself. It puts far more focus on the company and less on its investment banker. An IPO in China is not so much a test of an underwriters marketing prowess and placement network, but more state-directed capital deployment to companies deemed by the CSRC to be most suitable and fit to receive a slice of the publics savings. Who the underwriter is and how they operate are basically afterthoughts. This may offend against the market principles of a lot of financial professionals, that the only real IPO test a company should need to pass is if an investor will send a check to buy its shares. But, safety first seems a good principle for China at this stage. Private companies have only had access to Chinas capital markets, in a substantial way, for two years, with the opening of the Chinext ( board. The stock market is now and will remain the lowest cost way to finance the growth of private enterprise in China. Everyone stands to lose if confidence is badly shaken, or a scandal takes down one of these once-private now-public companies. For this reason, though many investment professionals are mystified by its decisions and sudden about-faces, the CSRC deserves support and respect.

Teaching the Elephant to Dance Chinas SOEs Transform

Over the last thirty years, China has gone from a
country where just about all companies were stateowned enterprises (so-called SOEs) to one where now fewer than 30% are. Much of the dynamism in Chinas domestic economy comes from these newer private companies. There are some very strong SOEs dominating key sectors of Chinas economy, including China Mobile, Sinopec, ICBC and other large banks, as well as airlines and utilities. These companies have also been partially privatized by selling minority stakes on global stock markets. This has provided huge amounts of new capital and brought with it improved performance and corporate governance at these top SOEs. But, many SOEs have failed, while others languish with inefficient production, overstaffing and outmoded products. For many of these, the prognosis is not good. But, at the same time, there is a entrepreneurial transformation getting underway at some of these SOEs. Managers are beginning to act more like owners and less like civil

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servants. We are seeing this now in our work. Some of the most interesting companies were talking to are SOEs eager to bring in outside capital as a first step towards privatization, and subsidiaries of larger SOEs looking for ways to split themselves off from their parent and go public independently. We expect to see more and more private capital, particularly from private equity firms, going into SOEs. In some cases, the investors will find ways to take majority control. In others, they will link their minority investment to a corporate restructuring that gives the SOEs management equity, warrants, or other incentives to improve performance and profitability. The likely result: some of Chinas more tired SOEs are going to get a big dose of free market adrenalin. At the moment, there are lots of legal hurdles for private capital to enter into an SOE. The process is opaque. Were spending a fair bit of time on behalf of several SOEs trying to figure out workable legal mechanisms. To succeed, any deal will take time and need champions in higher levels of government. But, practical economic policies tend to triumph in China. Private capital is, without question, the best option to improve the profitability and future prospects of many SOEs. This is good for employment, good for economic growth, good for worker incomes, good for accelerating development in inland China. These are all core policy goals in China. Were not able to discuss details or provide company names, but can give an outline of several of the most interesting SOE transactions we are now working on. This should give a sense of the kind of changes that may be on the way for SOEs. In one case, a subsidiary of one of Chinas largest publicly-traded SOE construction holding companies is looking for ways, with the parent companys encouragement, to spin itself off, raise private equity capital, and then try for an IPO. Though it contributes only about 5% of the parent companys total revenues and operates in different markets than the parent, this subsidiary is one of the largest, most successful companies in its industry in China. Its profits this year should exceed Rmb 650mn (USD$100mn). Because the parent company is already public, this subsidiary needs to fight for capital with other larger sister companies inside the conglomerate. It usually comes up short. With access to new capital, the subsidiarys current managers are confident they could double the size of the business (both profits and revenues) within two to three years. Outside of China, spinning off a subsidiary or selling a minority stake in an IPO is a fairly straight-forward process. Not so in China. Under current rules, the CSRC, Chinas stock market regulator, will not allow the parent simply to spin off the subsidiary through an IPO. There are related party transactions and deconsolidation issues. So, we are looking at ways for a large strategic investor to buy a controlling stake in the subsidiary, then pour in as much as $250mn in new capital. The subsidiary will then build up its business to where it could either qualify for an IPO three to five years later, or sell itself back to the parent. The management of this subsidiary is quite keen to put in their own money and become shareholders if their business can be separated and put on a path to IPO. They have done a very solid job building the business to its current scale, and would likely do markedly better if they had a real stake in the performance of the company. In another deal we are working on, a chemical company now majority owned by Sinopec is bringing in new capital to buy the Sinopec shares and recapitalize the business. The company was started seven years ago by a private entrepreneur, who raised the original capital from Sinopec. The entrepreneur now controls about 40% of the companys equity. Through the deal were working on, he will become the majority owner and the private equity investor will own the rest. Were also in discussions with the international division of one of Chinas giant SOE electricity companies. This group already has sizable projects and revenues in Southeast Asia and Russia, where

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it built and operates large hydro and gas-fueled power plants. The international division, however, is being held back by high debt levels at the SOE parent. This means the international division has trouble borrowing enough to finance its continued growth. Since the international division is already structured legally as a Hong Kong company, it should be possible for it to raise private equity then IPO in Hong Kong. We think this division can raise as much as USD$500mn in the next three years, both in private equity and IPO. These three (the construction subsidiary, the chemical company and international power plant business) are all very solid businesses that outside investors will likely flock to. Were also trying to find a way to help a more troubled smaller SOE based in central China. They make certain types of special fiberglass. The core business is fundamentally sound, but is stuck also doing some other things that lose money. It is too small now to qualify for an IPO, and is having a hard time in the current environment increasing its bank borrowing. The existing managers are eager to have an outside private equity investor come in and not only provide the capital, but also help improve manufacturing efficiency and marketing, and chop away the loss-making parts. They think an investment of Rmb 50mn could increase profits by a similar amount within two years. As anyone with experience will tell you, working with SOEs can be a complicated and timeconsuming process, particularly compared to dealing with a company founded and run by a private entrepreneur. But, the changes underway at SOEs represent ones of the most significant transformations now taking place in Chinas economy. With new capital and perhaps new ownership structures, many SOEs are going to thrive as never before. Their greater efficiency and greater profits will be a challenge for the private sector, but overall will be a plus for China.

Xinjiang is Changing the Way China Uses and Profits from Energy
The Two truisms about China should carry the
disclaimer except in Xinjiang. China is a denselypopulated country, except in Xinjiang. China is short on natural resources, except in Xinjiang. Representing over 15% of the Chinas land mass, but with a population of just 30 million, or 0.2% of the total, Xinjiang stretches 1,000 miles across northwestern China, engulfing not only much of the Gobi Desert, but some of Chinas most arable farmland as well. Mainly an arid plateau, Xinjiang is in places as green and fertile as Southern England. Underneath much of that land, we are beginning to learn, lies some of the worlds largest and richest natural resource deposits, including huge quantities of minerals China is otherwise desperately short of, including high-calorie and clean-burning coal, copper, iron ore, petroleum. How, when and at what cost China exploits Xinjiangs natural resources will be among the deciding issues for Chinas economy over the next thirty years. Already, some remarkable progress is being made, based on two past visits Because of its vast size and small population, Xinjiang hasnt yet had its mineral resources fully probed and mapped. But, every year, the size of its proven resource base expands. Knowing theres wealth under the ground, and finding a costeffective way to dig out the minerals and get them to market are, of course, very different things. Until recently, Xinjiangs transport infrastructure roads and railways was far from adequate to provide a cost-efficient route to market for all the mineral wealth. That bottleneck is being tackled, with new expressways opening every year, and plans underway to expand dramatically the rail network. But, transport cant alter the fact Xinjiang is still very remote from the populated core of Chinas fast-growing industrial and consumer economy. Example: it can still be cheaper to ship a ton of

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iron ore from Australia to Shanghai than from areas in Xinjiang. Xinjiangs key resource, and the one with the largest potential market, is high-grade cleanburning coal. Xinjiang is loaded with the stuff, with over 2 trillion tons of proven reserves. Let that figure sink in. Its the equivalent of over 650 years of current coal consumption in coal-dependent China . The Chinese planners goal is for Xinjiang to supply about 25% of Chinas coal demand within ten years. Xinjiangs coal is generally both cleaner (low sulphur content) and cheaper to mine than the coal China now mainly relies on, much of which comes from a belt of deep coal running through Inner Mongolia, Shanxi and Shandong Provinces. Large coal seams in Xinjiang can be surface mined. Production costs of under Rmb150 a ton are common. The current coal price in China is over four times higher for the dirtier, lower-energy stuff. For all its advantages, Xinjiang coal is not going to become a primary source of energy in China. The Chinese government, rightly, understands that the cost, complexity and long distances involved make shipping vast quantities of Xinjiang coal to Eastern China unworkable. Moving coal east would monopolize Xinjiangs rail and road network, causing serious distortions in the overall economy. Instead, the Xinjiang government is doing something both smart and innovative. It is encouraging companies to use Xinjiangs abundant coal as a feedstock to produce lower cost supplies of industrial products and chemicals now produced using petroleum. All kinds of things become costefficient to manufacture when you have access to large supplies of low-cost energy from coal. Shipping finished or intermediate goods is obviously a better use of Xinjiangs limited transport infrastructure. Ive seen and met the bosses of several of these large coal-based private sector projects in Xinjiang. The scale and projected profitability of these projects is awesome. In one case, a private company is using a coal mine it developed to power its $500mn factory to produce the plastic PVC. The coal reserve was provided for free, in return for the companys agreement to invest and build the large chemical factory next to it. The cost of producing PVC at this plant should be less than one-third that of PVC made using petroleum. Chinas PVC market, as well as imports, are both staggeringly large. The new plant will not only lower the cost of PVC in China but reduce Chinas demand for petroleum and its byproducts. Another company, one of the largest private companies in China, is using its Xinjiang coal reserve, again supplied for free in return for investment in new factories, to power a large chemical plant to produce glycerine and other chemical intermediates. This company is already a large producer of these chemicals at its factories in Shandong. There, they run on petroleum. In the new Xinjiang facility, coal will be used instead, lowering overall manufacturing costs by at least 20% 30% based on an oil price of around $50. At current oil prices, the cost savings, and margins, become far richer. The key, of course, is that the companies get the coal reserve for free, or close to it. True, they need to build the coal mine first, but generally, that isnt a large expense, since it can all be surfacemined. This means that the cost of energy in these very energy-intensive projects is much lower than it would be for plants using petroleum or, to be fair, any operator elsewhere who would need to purchase the coal reserve as well as build the capital-intensive downstream facilities. The Xinjiang projects should lock-in a significant cost advantage over a significant period of time. As investments, they also should provide consistently high returns over the long-term. While the capital investment is large, were confident the projects are attractive on risk/return basis, and that in a few years time, these private sector coal-forpetroleum projects will begin to go public, and become large and successful public companies. The Xinjiang government keeps close tabs on this process of providing free coal reserves for use as a feedstock. Since in most cases, these projects are looking to enter large markets now dominated by petroleum and its byproducts, there is ample room for more such deals to be done in Xinjiang.

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Deals are getting larger. Chinas largest coal producer, Shenhua Group, announced it would invest Rmb 52 billion ($8 billion) on a coal-to-oil project in Xinjiang. The company plans to mine 70 million tons of coal a year and turn it into three million tons of fuel oil. Remote and sparsely-populated as it now is, Xinjiang is going to play a decisive role in Chinas industrial and energy future, just as the development of Americas West has helped drive economic growth for over 100 years, and created some of Americas largest fortunes. Our prediction: Chinas West will produce more coal and mineral billionaires over the next 100 years than Americas has over the past hundred. Despite its scale and global importance, this company is never listed among the biggest private companies in China. Its owner is never included among the ranks of the countrys private sector billionaires. Just how unknown is this remarkably successful entrepreneur? Heres one measure. Believe me, Im a big nobody in China. But, a Baidu search turns up more articles and references to me and my company than to this company boss and his. In terms of orders of magnitude, his company employs about 2,000 times more people than mine, and occupies a premises thats about, well, 190,000 times larger. None of my competitors, as well as virtually no credible PE firms, have visited the company. My purpose here is two-fold: to shed a little light on a remarkable individual entrepreneurial achievement and also to give some sense of the scale of entrepreneurial greatness in China. I find myself, more often than Id like, drawn into discussions occasionally arguments with people in the US and Europe about how entrepreneurship in China is in a class by itself, compared to everywhere else in the world, excepting perhaps the US and Israel. Entrepreneurs are more numerous here (over 70 million private companies) and the best ones, numbering at least in the thousands, have created more wealth and spawned more positive societal progress in the last ten years than any other single group of people on the planet. I live in a perpetual state of wonder, doing what I do for a living in China, having occasion to meet entrepreneurs of the caliber of this particular boss. He is about as modest an individual as you would likely ever run across. The only obvious concession to his enormous wealth is a rose gold watch he wears along with standard-issue baggy Chinese suit. If he sat next to you on a plane, my guess is youd pin him as the owner of a small hardware store, not the owner of the worlds largest manufacturing business for a component used in a lot of whats for sale there. His office is hardly palatial, and sits just above the oldest section of his giant factory complex. He never went to college, and has no engineering or

"If You Are Going to Do Something, Do It Big"

The first thing that strikes you is complete
geographic implausibility of it all. In a rural corner of the sparsely-populated and dusty Loess Plateau in Northwestern China, sits an enormous complex of factories, dormitories, roads, and train tracks occupying an area of 38 square kilometers (14.6 square miles, almost 19 million square feet). Thats over half the size of Manhattan, 58 times larger than LAs Disneyland, three times larger than the worlds busiest international airport, Heathrow in London. The site belongs to a single Chinese company. Its private, been in business less than a decade, has come from nowhere to become the worlds largest manufacturer of a critical component used in steel production, with likely revenues this year of over USD$1.5 billion (Rmb10 billion), profits of over USD$130 million , and assets of over USD$2.4 billion (Rmb 15 billion). Its 99% owned by its founder and chairman, with the other 1% held by his wife and daughter. By any measures, it is among the largest private industrial companies in the world, and certainly among the fastest ever to get to $1 billion in sales.

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technical background, despite founding and now running one of the more complicated large-scale engineering and manufacturing businesses youd ever hope to see. Everything about the man, except his ego, is huge. If you are going to do something, he tells me, do it big. This applies not only to the huge area his business occupies, but the size of the investments he is making in its future. He is taking his business downstream and building, simultaneously, at least four huge new production sites, with total planned investment of over $3 billion. The local government is busy decapitating the top half of a silt mountain to create a level 500 acre site (about one square mile) for one of these new production areas. He begins building on it this year. As I drove away from the factory area, I remarked to my colleague that the whole complex must be a source of intense interest at the CIA and National Security Agency in Washington, DC. Satellite photos will show the vast scale of this enterprise, as well as all the construction taking place. One recently-completed building is four stories tall and a mile long, all indoors. My guess is the two spy agencies arent all that sure what exactly is being produced or planned here. I drove through it. Within a year, it will start producing steel products for the auto and home appliance industry. How did this one entrepreneur build such a huge business is such a short time? Obviously, good timing, luck, some support from his local government and banks played a part. But, one key factor was a gamble he made in 2008 that paid off big time. When the financial crisis hit, his stateowned competitors (there were once three within a few hundred miles of him) cut way back on raw material purchases. This boss did the opposite. He exploited a steep drop in commodity prices, bought big and so locked in very large profits when customer demand began to pick up in 2009. Of course, had prices kept falling, he would have likely been bankrupt. His state-owned competitors? Now, all out of business. Just about every yuan of profit he earns is poured back into expanding production. His bank loans are moderate about 10% of total assets. Hes only drawn down 70% of the credit lines provided by local banks. Measured by scale (factory size, employees, revenues) his company is similar to many larger SOEs in China. Asked to make a comparison, he explains that SOEs target only top line growth girth for its own sake. He is far more focused on making money. The projected annual rate of return on newer projects is well above 25%. Hes thinking about an IPO within two to three years. His business could have a market capitalization at that point in excess of USD$8 billion. An IPO on that scale will bring him a lot of unwanted notoriety. He would likely instantly be vaulted into the ranks of the five hundred richest people on the planet. Billionaires in China rarely have it easy. Quite a few seem to end up in prison, or targeted by waves of bad publicity. For him, the real appeal of going public is the potential to raise an additional $1.5 billion to $3 billion to invest in further downstream expansion. It was one of the great delights of my 35-year professional career to meet this entrepreneur, tour his factories and eat in his dining room. At this moment in history, China is the entrepreneurial center of the world. --- Peter Fuhrman Chairman

CHINA FIRST CAPITAL

Tel: 0755 33222101 Email: ceo@chinafirstcapital.com Website: www.chinafirstcapital.com

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