China Private Equity Capital Markets 2014, Research Report From China First Capital

China Private Equity 2014
Trends, opportunities, analysis

This proprietary research note is intended exclusively for use of the recipient. It contains confidential information.
All contents are copyright 2014 . www.chinafirstcapital.com ceo@chinafirstcapital.com

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www.chinafirstcapital.com
Introduction
Four words best describe the changes in China's
private equity industry over the last decade:
perpetual, dramatic, disruptive, unpredictable. A
decade ago, China was a private equity backwater,
with a handful of firms and few success stories.
Things really began to heat up in 2005 when
Chinas largest internet search company Baidu
went public on NASDAQ. Its share price tripled on
the opening day, creating paper fortunes for
Google, which owned a minority stake, as well as
several US venture capital firms that invested
years earlier in Baidu.
The race was on. Giants of Silicon Valleys venture
capital industry, including Sequoia Capital and
Kleiner Perkins, opened offices in China, along with
a growing number of well-established international
private equity firms. Everyone seemed to want in.
Capital raised to invest in China PE deals grew at
least five-fold from 2005 to a total of over $100bn.
IPO exits went from few to over 300 in some years.
The number of active PE firms went from a few
dozen investing only dollars to over 1,000,
including hundreds of newly-organized funds
investing Renminbi.
If the ride up was fast, the slide down was even
quicker. By early 2013, most exits had ceased and

with it new capital-raising. PE firms' portfolios
ended up struggling under the collective weight of
over 7,000 unexited PE investments. With fund
lives growing shorter and profit distributions to
Limited Partners few and far between, China
private equity turned from one of the most
dynamic and attractive investment classes in the
world to one of the more troubled.
In 2014, there are signs that the worst may now
be over, that China PE is pulling out of a tailspin.
It's impossible to quantify how big the losses for
LPs may run, how many of these newly-established
PE firms will close up shop, when this once-
booming and supremely promising industry will
recover its lost luster. China private equity is
entering a period of retrenchment and maturation.
IPOs have now returned, and with it, the likelihood
that more China PE deals will achieve successful
exit. But, going forward, the PE industry in China
will need to make greater use of all other exit
channels as well.
Private equity has been a powerful force for good
in China. Entrepreneurs, consumers, investors
have all benefitted enormously. Profit opportunities
for GPs and LPs remain large. Great companies in
need of capital abound.
INSIDE THIS REPORT:

China PEs Big Bet 3
Chinas High-Tech Ambitions & Disappointments 5
Taobao Is Killing Off Chinas Shopping Malls 7
3M in China: a Success Story 10
How China Buried India 11
PE Partner Churn 13
Investors vs. Asset Managers 15
Unmanageable Beijing 16
Chinas Farmland: Who Owns & Farms It 18
China Logistical Nightmare 19
The Big Fours Big Headaches in China 21
Tiananmen 25 Years Later 23

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PE capital is now a main source of expansion
capital for China's private sector companies. Bank
loans remain difficult and costly. PE capital in
China has an especially high multiplier. In thirty
years, China's private sector has gone from non-
existent to producing well over half of the country's
entire GDP. PE money has in the last decade
played an increasingly vital role in this, providing
over $100 billion in capital as well as expertise and
encouragement to entrepreneurs. Today's China
would be unrecognizable had no private equity
industry emerged. More so than in any other
country, it is true to say that virtually all of the
country's largest, most competitive, most famous
and dynamic private businesses were financed by
private equity or venture capital.

The PE Worlds Big Bet
on Chinas Internet and
Mobile Services Industry
Herd behavior is a familiar enough phenomenon
across the PE and VC world. But, the situation in
China has reached mythic proportions. At the
moment, there is little, if any, PE money going to
large, profitable, mature, comparatively de-risked
manufacturing companies. Instead, almost all the
publicly-announced deals in 2014 are investments
in a variety of mainly online shopping sites or
mobile-phone travel, game and taxi-booking
services, none of which has a true technological
barrier to entry, and all of which seem to hinge
mainly on the same prayed-for low-probability
outcome: a purchase down the road by Chinas two
internet leviathans, Tencent or Alibaba.
A US IPO is also at least theoretically possible. This
year has already seen successful IPOs for Chinese
internet and mobile companies, including Zhaopin,
Cheetah Mobile, Qihoo 360, Leju, Chukong
Technologies, Sina Weibo, Tuniu. But, PE deals
being done now are for smaller, newer less well-
established China companies that mainly face a
steep failure-filled mountain climb of at least two
to three years to even reach a point at which an
IPO in New York might even be possible.
It is true that Chinas online shopping and services
industry is booming. Problem is, almost all the
money is being earned by these same two large
firms. In online shopping, 80% goes to Alibaba. In
online gaming, a far smaller money-maker,
Tencent is about as dominant. Both have done a
few deals in the last year, buying out or investing
alongside PE firms in smaller Chinese companies
which have gained some traction. At the same time
a few Chinese internet companies have gone public
in the US and Hong Kong. But, the overall
environment is much less positive. There are far
too many me too businesses with business
models copy-catted from the US pouring out PE
and VC cash to buy customers or a thin allotment
of a 20 year-old Chinese males online gaming
budget.
China is the worlds best mass manufacturer. In
just about every imaginable category, China has
the worlds largest or second-largest domestic
market. Simply put: in our view there are so many
better, less risky, more defended Chinese
companies out there than the ones now getting
most of the PE and VC time and money.
Our bet is that Tencent and Alibaba will also soon
lose their appetite for buying smaller Chinese
internet players. They are at a similar phase as
companies like Amazon, Google, eBay, Cisco,
Microsoft, Electronic Arts, IAC/InterActiveCorp,
once were. These giants at one time bought small
US internet companies by the bucket-load. But,
most have either quit or cut back doing so. The
businesses usually fail to prosper, are non-core,
and prove hard to integrate. Minority deals usually
turn out worse. Corporate investors make bad VCs.
In other key respects, there is every difference in
the world between the US VC scene and this
current activity in China. The US has far more
trade buyers for successful VC-backed companies,
far more genuine innovation, far more success
stories, far less monopolistic internet and mobile
industries, and a far richer early adaptor market
to tap. You dont need to look back very far to see

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where this kind of investing activity can lead. Its
only a little more than two years since PE firms
poured hundreds of millions of Renminbi into
Chinese group shopping sites modeled to some
extent on Groupon from the US. Almost all these
companies are now out of business or losing
serious money. Chinese like group-buying. They
just dont let any company make any money from
offering such a service.
Scan through the weekly summaries of new PE and
VC deals in China, as digested by Asia Private
Equity in Hong Kong. Virtually all involve deals to
invest in online and mobile services.
We talk or meet with PE partners on a regular
basis, but can recall only a single discussion, over
the last six months, where the PE firms primary
focus was not on these kind of deals. This
lonesome PE is the captive fund of one of Chinas
largest state-owned automobile groups. At this
stage, about as differentiated as Chinese PE
investment gets is whether the money should go
into one of the many online sites for takeaway
meals or one of the even larger number selling
cosmetics.
China PE is slowly emerging from a prolonged
period of inactivity and crisis, the result of both a
slowdown in IPO activity and PE portfolios bloated
with unexited deals. Its good to see some sign of
animal spirits again, that some PE firms at least
are looking to do deals. But up to now, it looks like
some bad old habits are being repeated: too many
PE firms enslaved to the same investment thesis,
chasing the same few companies, bidding up their
valuations. It's an ongoing example of inadequate
diversification by industry or stage.
In the US, in most VC-backed companies, one of
the busiest members of senior management is the
head of business development. This job is often to
find strategic partnerships, barter and co-bundling
deals to generate more growth at less expense.
This kind of thing is much rarer in China. Instead,
for most, the primary method of customer
acquisition is to spend a lot of money on Baidu
advertising.
Baidu is far more accommodating than Google. Its
the dirty, not-so-well-kept secret of Chinas
internet industry. Baidu, which handles over 60%
of all Chinese search requests, lets advertisers buy
placement on the first page of what are
called organic search results. There is basically
no such thing in China as Google's most relevant
search results. The only search algorithm is: who
has paid us the most. Its one reason Googles
pullback from the China market is so damaging
overall for the Chinese internet.
The pay to play rules in Chinas internet lead to
companies taking lots of expensive short cuts,
often burning a lot of PE and VC firm cash. Theres
more than a little here to remind us of the Internet
Bubble years in the US. CFC's chairman ran a VC
firm in California right after the bubble burst. He
still shakes his head at some of the deals this VC
firm invested in before he got there, when, as is
now in China, pouring lots of LP money in any kind
of dot.com or shopping site was seen as prudent
fiduciary investing. Things turned out otherwise.
They turned out messy. They will too with this PE
infatuation with online and mobile anything in
China.

China High-Tech: Giant
Ambitions Cant Disguise
a Disappointing Record
of Achievement

China, the innovation nation. With nine times
more engineering graduates and more patents filed
each year than in the US, China is transitioning
quickly away from its roots as a copycat, knockoff
economy to become a potent new high-tech
power." Weve all seen the headlines, read the
reports.
No story about China, , no prediction about Chinas
future gets more attention or more traction from

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consultants, authors, experts, policy analysts. It
encapsulates the unanimous hopes of China's
leadership, and the fears of America's. China is
now standing at a critical stage in that its economic
growth must be driven by innovation, declared
Chinas ruling State Council in May.
While China is making strides, the reality is
sobering. For all the hype, the government policies
and cash, China remains a high-tech
disappointment, more dud than ascending rocket.
As an investment bank focused on China, we very
much wish it were otherwise. But, we see little
concrete evidence of a major change underway.
The best the many boosters can offer is, give it
more time and its bound to happen. In other
words, they make their case unfalsifiable, by
saying today's China's tech famine will turn into a
feast if only we are prepared to stand by the
empty banquet table long enough.
CFC's chairman puts it like this, "unlike a lot of
those forecasting China's inevitable rise to a
technology superpower, I've actually met and
talked with hundreds of Chinese tech companies,
and before that run a California venture capital
firm with investments in the US, Israel and Europe.
I've also run as CEO a high-tech enterprise
software company in the US that used proprietary
technology to gain leading market position and
ultimately a high price from an acquirer when we
sold the business. So, I've been around the tech
world a long time, both in China and elsewhere.
Rule number one: deal with the facts in front of
you, not wishful thinking. Rule number two: a
high-tech economy is not a quotient of national IQ,
national will, national urgency or national subsidies.
If it were, China might well by now be at the
epicenter of global innovation."
High-tech is meant to be a savior of China's
economy, delivering higher levels of affluence in
the future and an escape from the so-called
"middle income trap" that has slowed growth
elsewhere in Asia. But saviors have a nasty habit
of never arriving. Let's investigate why China has
up to now made little progress in high-technology.
But, first, we want to highlight one glaring example
of how China has been unable, despite momentous
efforts across more than a decade, to reach a first
rung of high-tech engineering competence. Its
failure to design and serially produce jet engines.
Military power both requires and underpins high-
tech success. Any doubt about this was eliminated
by the collapse of USSR. CFC's chairman was lucky
then to have a front-row seat for that event. He
spent years as a Forbes journalist visiting the
USSR, surveying both its military and civilian
industries, its indigenous technology base. He was
one of the few who got to spend time, for example,
inside the top-secret Soviet rocket program,
including visiting main factories where its rockets
and space station were built. The rocket program
was the pinnacle of Soviet tech achievement. But,
it proved to have little overall spinoff benefit for
USSR economy. It was a dead-end. Note: the
Soviet Union then, as China today, had far more
engineers and engineering graduates than the US.
US's military supremacy, then and now, rests as
much on Intel and Broadcom as it does on
Lockheed Martin fighter jets and GD nuclear
submarines. The US has a huge, fast-adopter
civilian technology market with strong competitive
dynamics, something China is without. This means
US military then and now can procure the best
chips, best integrated software and systems
cheaply and quickly from companies that are
mainly serving the civilian market. The Soviets had
no civilian high-tech industry, no market forces.
The Soviet military was exposed as a technology
pauper by the 1989 Iraq War.
China is better off in many ways. It manufactures
a lot of the world's most advanced civilian high-
tech electronics products. This gives China huge
advantages the USSR never had. All the same, the
USSR by the mid-1950s was producing jet engines
for military and civilian use. To this day, China
relies on Russian factories, using Soviet-successor
technologies, for its advanced jet engines. Russian
jet engines are generally considered at least a
generation behind the best ones manufactured
now in the US, France, UK.
It is puzzling to us, and certainly even more so to
China's military leadership, why China is still not

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able to make its own advanced jet engines. The
reasons, as far as we can judge, also cast light on
problems China has, and likely will continue to
have, developing a globally-competitive indigenous
technology base. In the case of jet engines, the
problems are at manufacturing level (difficulty
to serially produce minute-tolerance machinery),
at the material level (lack of special alloys) at the
industrial level. There is only one designated
monopoly aircraft engine producer in China, so no
competitive dynamic as in the US between GE and
P&W for the design, monitoring and lifecycle
management of jet engines.
A recent report on China's jet engine industry puts
the technology gap in stark terms. "In some
areas," it concludes, "Chinese engine makers are
roughly three decades behind their U.S. peers."
This challenge, to bring all the parts together in a
high-technology manufacturing project, is also
evident in China's failure, up to now, to develop
and sell globally domestically-developed advanced
integrated circuits, pharmaceuticals, new materials.
In drug development, China by some estimates
has spent over $10 billion on pharmaceutical
research and up to now has had only one
domestically-developed drug accepted in the global
market, the anti-malarial treatment Qinghaosu
(artemisinin). Interestingly, it is derived from an
herbal medicine used for two thousand years in
China to treat malaria.
It's simply not enough to count engineers and
patents or the content of government technology-
promotion policies. China lacks many of the basic
building blocks of high-tech development. Included
here is a mature, experienced venture capital
industry staffed by professional entrepreneurs and
technologists, not MBAs. A transparent judicial
system is also essential, not only for protecting IP,
but managing the contract process that allows
companies to put money at risk over long-periods
to achieve a return. Non-Disclosure and Non-
Compete agreements, a backbone of the
technology industry in the US, are basically
unenforceable in China. Anywhere this is the case
you can about wave goodbye to big-time
technology innovation.
While ignoring the troubling lessons of China's
failure to produce a jet engine (as well as jet
brakes and advanced radar systems) the boosters
of China's bright tech future most often cite two
mobile phone-related businesses as proof of
China's rising innovation. The two are Xiaomi
mobile phones and Tencent's WeChat service. Both
have had success in the last year including getting
some traction in markets outside China. Look a
little deeper and there's less to be positive about.
Xiaomi is a handset manufacturer that now has a
market valuation of over $10 billion, higher than
just about any other mobile phone manufacturer.
It relies, though, mainly on the same group of US
companies (Broadcom, Qualcomm, Google) for key
technologies used in its phones. They, along with
UK chip-maker ARM are the ones making the real
money from Android phones. In addition, Xiaomi's
phones as are many cases manufactured by
Taiwanese company Foxconn. As of now, China has
no domestic company that can achieve Foxconn's
levels of quality at low manufacturing cost.
Foxconn does this at factories in China. Its superior
management systems for high-volume high-quality
production underscore another critical area where
China's domestic technology industry is weak.
With WeChat, it's done some impressive things in
signing up over 300 million users. The basic
application is similar to that of Facebook's
WhatsApp and others. It would be hard to suggest
Tencent has shown huge technology leadership in
this area. It's real technology strength, though, is
in its back end, in building and managing the
servers to store all the content that is sent across
WeChat, including billions of video and audio files.
Whatsapp doesn't have similar capacity. In fact, it
points with pride to the fact it doesn't backup for
storage any Whatsapp customers' conversations.
Tencent does this because it's required to do so by
Chinese internet rules, and government's policies
to monitor internet content. Tencent might be able
to commercialize and sell globally its backend
storage architecture, but it's not clear anyone
would be interested to own it. It's a technology
that evolved from specific Chinese requirements,
not market demand.

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Last month CFC's chairman spoke on a panel at a
conference for the global bio-manufacturing
industry. Bio-manufacturing is precisely the sort of
high-tech endeavor where China most needs to up
its game. Bio-manufacturing relies on a mix of
first-rate science, cutting-edge manufacturing
techniques and capable management. After all the
talk and the establishment of dozens of
government-funded high-tech science parks across
China, the simple verdict was China has yet to
achieve any real success in this industry.
China is not alone, of course, in having its
difficulties creating and nurturing a globally-
competitive indigenous technology industry. In
their time, most of the world's advanced major
economies have all tried -- Germany, France,
Japan, UK. All lavished government subsidies to
foster domestic innovation.
All made technology a policy priority. Yet, all have
basically failed. If anything, the US is now more
dominant in high-technology than it was at any
earlier time in history. The US is home to most of
the companies earning high margins, market
shares and license fees for their proprietary
technology.
China has already achieved what no other country
has: in the course of a single generation, it has
achieved the highest-ever sustained rate of growth,
and so lifted hundreds of millions of its citizens out
of poverty. This achievement shows the brilliance
of the Chinese people, the wisdom of its policy-
makers. Both will continue to deliver benefits for
China across generations to come.
For China, becoming a tech power is neither
certain nor impossible. Progress can be hurt, more
than helped, by those who engage more in hype,
in predicting certain outcomes, rather than
critically assess the impediments, and learn
lessons from the failed efforts so many other
countries have had in developing a technology
industry.
New thinking about innovation, and how to
encourage it in China, is still lacking.
Alibabas Taobao and
Other Online Merchants
Are Pushing Traditional
Retailers in China
Towards Extinction
Welcome to the desolate future of shopping
mall retailing in China.
-

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This seven-story skylit shopping mall occupies a
premier spot in a high-rent commercial district in
booming Shenzhens main shopping street, with a
huge underground parking lot and entrances that
link it directly with a busy Metro stop. And
yet, everywhere you walk, floor after floor, retail
shop fronts are boarded up, with most stores
closed down. Only the ground floor supermarket,
top floor Multiplex movie theater, basement chain
restaurants and a large Starbucks are thriving.
Thousands of square meters of retail space, fully
rented as recently as twelve months ago at some
of the highest commercial rents in the world, are
silent and vacant. No customers, no tenants, no
rent income.
Malls are starting to empty out in China, but
Chinese are richer, and spending like never before.
Overall, retail sales rose 13% in 2013. The
paradox can be explained by a single word:
Taobao. It is Chinas largest online shopping
business, and the anchor asset of Alibaba Group,

8
now preparing for one of the worlds richest-ever
IPOs on the US stock market. Taobao, along with
its sister site TMall, and a host of smaller online
retailers including Jingdong, Amazon China and
Wal-Mart-controlled Yihaodian, have landed like an
asteroid, and are wiping out the ecosystem
supporting traditional retail in China, especially
brand-name clothing shops.
The impact of online shopping in China is already
far more wide-ranging than anything seen in the
US or elsewhere. The reason is price. Taobao and
others sell the same brand-name products
available in shopping malls, but at prices often
30%-50% cheaper. More even than rising incomes,
online shopping is the most powerful force in China
for raising ordinary Chinese living standards and
purchasing power.
Online shopping is everywhere in the world, at its
heart, a price discovery tool. And Chinese are now
discovering, in their hundreds of millions, they
have been getting seriously ripped off by
traditional stores, especially those selling foreign
and domestic brand-name clothing and consumer
electronics. They usually occupy 70% or more of a
malls retail floor space.
Alibaba and other online merchants are joyously
surfing a tidal wave of dissatisfaction with the high
price of store shopping in China. Not only are
brick-and-mortar stores prices much higher than
buying online, they are also often more expensive,
in dollar-terms, than the same or similar Made-in-
China products sold at Wal-Mart or Target in the
US.
Those two giant chains have fought back against
online retailers in the US by using their buying
power to offer brand name products at low prices.
No retailer in China is really attempting this.
Retailing in China is both fragmented and
uncreative. As dynamic and innovative as China is
in many industries, we've yet to see even one
great home-grown retailing business here in China.
Theres also a big problem in the way Chinese
shopping malls, especially high-end ones, are
operated. Chinese mall owners are mainly a motley
assortment of one-off developers who used
government contacts to nab a valuable piece of
commercially-zoned downtown land at a fraction of
its market value. They then mortgaged the
property, built a fancy shopping palace, and now
take a cut of sales, along with a baseline rent. This
revenue-sharing discourages retailers from cutting
prices. If they do, they will fail to meet the
landlords minimum monthly turnover figure.
Compounding the pressure on traditional retailers,
mall owners often give the best ground-floor
locations to global brands like Louis Vuitton or
Prada, who pay little or no rent, but are meant to
give the mall a high-class ambiance. The big luxury
brands China outlets seem to have rather anemic
sales, but use their China stores as a form of brand
promotion richly subsidized by mall owners.
Domestic brands are shunted to higher floors.
Fewer shoppers venture up there, and so the
stores will often end up failing.
The result, as in the photo above taken on a recent
Sunday, floor after floor of vacant space. China is
creating an entire new retail landscape a
glamorously-appointed mall in a nice part of town
whose upper floors resemble downtown Detroit
after a riot, with boarded-up shop fronts and
scarcely a soul.
Anywhere else in the world, a mall with so much
vacant space would either need to cut rents
drastically or hand the property over to the banks
that lent the money. Neither is happening. For now,
the banks can often afford to be patient. Malls that
have been around for a few years have probably
already paid off the loan principal. Newer loans
look far shakier. There are hundreds of bank-
financed high-end malls now under construction or
opening this year across China.
The stampede away from malls is only just
beginning. Though China has already overtaken
the US in dollar terms as largest online shopping
market, there is every sign that the shift to buying
online is accelerating and irreversible. Online sales
in China should reach 10% of total retail sales this
year, well above the US level of 6%. We project
this percentage will rise to over 15% within the

9
next decade. Thats because more Chinese will
shop online, especially using their mobile phones,
and because the range of items that are cheaper to
buy online is so much larger in China than
anywhere else.
For that, online merchants must also thank the
countrys parcel delivery businesses, led by
Shunfeng Express (). They charge so little
(about one-tenth the price of Fedex or UPS) and
are so efficient in getting your parcel into your
hands quickly that it makes economic sense not
only to buy higher-priced apparel, office supplies,
books and consumer electronics, but also packaged
food, soap, personal care items, even knickknacks
that sell for less than $1.
The retail stores that remain in shopping malls are
increasingly being used as free showrooms to
facilitate sales by online competitors. Chinese
shoppers go to stores to find what they like, try it
on, check the price, then go home and buy direct
from Taobao. Thats one reason malls are still
drawing crowds.
Online shopping is not only cheaper, customer
service is usually much better. Most merchants
selling on Taobao manage and run their own online
shops. Taobao is nothing more than an
aggregation of millions of motivated individual
entrepreneurs. They are available just about any
time, day or night, by phone or online chat to
answer questions, or even, when asked, offer an
additional discount. They are, in our experience,
smart, self-confident, friendly, competent.
Sales help in stores are often poorly-paid younger
women who cling together behind the cash register.
They clearly dont much enjoy what they are doing,
nor are they there to enhance the shopping
experience. Often just the opposite.
So whats going to happen to all the malls in China?
There are over 2,500 across the country, already
more than double the number of enclosed malls in
the US. More are opening around China every
week. Who will fill up all the space? Theres serious
money to be made by investors or operators who
can take advantage of the large disruptions now
underway in traditional retailing.
Restaurants in malls are still doing well, and they
dont have anything to fear from Taobao. But, food
outlets generally pay lower rent, per square foot,
than retail stores and occupy either the top or
basement floors. Premium office space is also still
in demand in the downtown areas where many
malls are located. Should malls be turned into food
and entertainment centers? Or converted to
commercial offices? Neither path looks easy.
The US went through a large wave of shopping
mall bankruptcies in the 1990s, as large operators
like DeBartolo and Campeau failed, and better
ones like Simon Property Group and Westfield
Group thrived. The good operators lowered costs,
improved the economics and did well as newer
retailers like Victorias Secret, Abercrombie & Fitch,
Hollister, Juicy Couture, H&M, Apple, Papyruys,
Teavana, Nordstrom honed retail formulas that
could withstand online competition.
Retailers in China are in such peril because they
charge too much, never innovate and do so little to
win the loyalty of their customers. Alibaba and
other online sellers are hastening their extinction.

3M in China: a
Magnificent Minnesota
Multinational

Through pain comes wisdom. US manufacturing
giant 3M has a superb business in China that by
sales, growth, product diversification, brand equity,
market share and margins must place it among the
very best, if not the best, US companies operating
here.
This overdue realization came courtesy of having a
nasty little cavity filled in China. As our chairman
squinted through the pain, he saw the dentist
reach for a small tube of 3M-branded epoxy to fill

10
up the hole in his tooth. 3M is American, like you,
right? she asked in Chinese. This is the best
product on the market.
Modern dentistry didnt really much exist in China
until around 20 years ago. Since then, the growth
has been hypersonic. Today there are about 60%
more dentists in China than in the US, 135,000
compared to 85,000. The number of dentists is
growing by 15,000 a year in China. 3M helped
build the dentistry market from the ground up, and
now enjoys a level of market penetration and trust
in China exceeding the US.
Dental products are just one among many dozens
of areas where 3M has built a large and profitable
business in China. Another one we know of:
reflective tape used on traffic signs and glow-in-
the-dark clothing worn by police and other first
responders. 3M enjoys something like a monopoly
here, during a time when no other country is
adding as many miles of roads, and as many bright
new road signs as China. We have a Chinese client
that tried, without much success, to compete with
3M in the market. Despite having better
government contacts and lower prices, this
Chinese company has gotten steam-rollered by 3M
in China.
In industrial adhesives, photovoltaic components
and, of course, Post-It Notes, the situation is the
same. 3M has flattened every Chinese competitor
that came after it. 3Ms China strategy is as simple
as it is successful: premium products, prices and
market shares.
3M has been in China since 1984, almost as long
as the country has welcomed American investment.
Over that time quietly but oh-so efficiently, it has
built a powerful business in China, with revenues
last year growing 16% to over $3 billion. China
sales are growing three times faster than overall
3M revenue. The companys China CEO is on the
record predicting 3Ms revenues in China will
overtake its sales in the US ($9.5 billion in 2013)
within the next ten years.
That would be an impressive achievement. But, we
wouldnt bet against 3M. It has as strong a
platform for growth in China as any company we
know of, domestic and international. It sells
hundreds of different products in over eighty
separate product categories in China. In a county
where no companys intellectual property (patents
and know-how) is meant to be safe from pirates,
3M has defended its secrets and stayed
comfortably ahead of local brand knock-offs and
copycats. Counterfeiting is a separate issue, and
probably 3Ms biggest problem in China.
In a way few, if any, other US multinationals have,
3M has managed to achieve significant sales and a
stellar reputation both in consumer and B2B
markets. As China grows richer, 3Ms strategy
looks smarter and smarter. Cheap, low-quality
products are being driven out of the market here.
Consumers, factories and government departments
are trading up. This leaves many low-end Chinese
brands in a very difficult and life-threatening
position. They can only compete on price in a
market thats increasingly price-insensitive. 3M is
precisely the kind of manufacturing company China
most sorely lacks a serial innovator with branded
products that can command higher prices.
Both dentists and handymen still stock lower-
quality Chinese-made products. They offer
customers a choice something one rarely runs
across in the US. You want the good imported stuff
or a cheap knockoff? The price difference can be
rather high. For cavity-filling compound, using 3M
product will cost you about three times as much.
To fix a chair leg using 3M glue its double the
price. But, the dentists and handymen we asked
say almost none of their clients are opting for the
local brands.
3M is admired just about everywhere for the
quality of its products. But, in China, it has an
almost saintly reputation. During the height of the
SARS epidemic in 2003, 3M disposable masks were
widely publicized in the Chinese media as the most
effective way to prevent the deadly disease. Today,
3M disposable masks are widely used by Chinese
for another purpose, to block out the pollution and
fumes that envelop big northern cities like Beijing,
Jinan and Shanghai.

11
Other US companies with large China businesses
have hit on tough times lately in China. P&G and
Coca-Cola Company are losing market share to
local competitors. Yum! Brands and Mondelez have
both suffered from perceptions they peddle
unhealthy food. Their best days in China are
perhaps behind them.
3M, meanwhile, quietly and steadily goes from
strength to strength. If any US company can add
another $7 billion in revenue in China over next
decade, 3M is the most likely.
3M not only introduced its products to China, it
also transplanted its rather unique American
Midwestern personality. 3M China is, by local
standards, modest, elf-effacing, even dull. It
doesnt advertise much, or throw its weight around
as one of the largest US companies operating here.
The Maplewood, Minnesota-based parent barely
even mentions China in its 2013 10-K annual
report.
When you are doing this well in the worlds
strongest-growing major market and beating up
your competitors, why tell the world about it?-

How China Buried India

Twenty years ago, India, not China, was the
object of CFC chairman's focus. Back then, he was
living in London and working as European bureau
chief for Forbes Magazine. In May 1994, a story he
co-wrote called Now We Are Our Own Masters
appeared on the cover of Forbes (Visit the CFC
blog to read the article.). It was the first time a big
American magazine took the risk to suggest India,
after so many years of pathetic growth, famine and
unending poverty, was ready for an economic
take-off. It turned out to be a pretty smart call.
Since then, Indias economy has surged, growing
seven-fold while poverty has declined steeply.

CFC's chairman tells the story here, at length: "I
spent about a month in India researching the
article, meeting with political and business leaders.
It was my third trip to the country. The first had
been in 1978, as a young backpacking college
student, on my way back to the US from a summer
in Taiwan studying Mandarin. The two most vivid
memories of that first trip nearly dying from
untreated amoebic dysentery, and hiding out for
days in a place called Aurangabad as masses of
Indian men rioted on the streets against the forced
sterilization policy of India Gandhi.
"It took another three years before I first set foot
in China. On a lot of levels, the two countries
struck me as similar back then, both in the extent
of the obvious poverty as well as the shared
disappointment some thirty years after each had
gained full independence as socialist states under
charismatic intellectual leaders, Jawaharlal Nehru
in India and Mao Zedong in China.
Indias GDP Growth 1950-2010

12
"China began its reform process a decade earlier
than India. I caught the first stirrings when I
arrived in Nanjing as a student in 1981. When I
went to India in 1994 for the Forbes article, it still
seemed plausible India might one day emerge as
the larger, more vibrant of the two economies.
China had suffered a sharp setback in 1989, during
the Tiananmen Square Protests of 1989, an event I
witnessed first-hand in Beijing. At the same time,
India had begun to liberalize and energize its over-
regulated and inefficient state-run economy.
"While Indias growth has since surpassed my
optimistic hopes in 1994, I firmly believe it will
never rival China. This chart below shows how far
the gap between the two has grown. Since 1994,
China has all but left India behind in its tailpipe
exhaust.

"In per capita PPP terms, China is now almost 2.5
times wealthier than India. Year by year, the gap
grows, as Chinas gdp expands faster than Indias,
while Indias birth rate is now almost triple Chinas.
"I havent been back to India since 1994. I have no
doubt its changed out of all recognition. Changed
for the better. Poverty is down. Exports are way up.
Its biggest misfortune may be having to compete
for capital, and for attention, with China.
"Living full-time and working in China now for
more than four years, Im more impressed than
ever how superbly China is engineered for rising
prosperity. The comparisons I read between India
and China generally give a lot of weight to the
difference in political systems, between Indias
raucous federal democracy with dozens of parties
and Chinas one-party centralized rule. The
indisputable conclusion: sound economic policies
are easier in China to design and execute.
"The few times Ive been asked to contrast the two
countries, I prefer to focus on their most valuable
long-term assets. India has English. China has
Confucius.
"India doesnt out-compete China in too many
industries. But, in two of these pharmaceuticals
and computer software English is probably the
main reason. Indias educated population is
basically native fluent in the language. China has
tried to make more of a game of it, especially in
computer software and services. But, China is now
and will likely remain a bit player in these two
large, global high-margin industries.
"India also has, overall, a more innovative financial
services industry. This isnt really the result of
widespread English, but the fact that India has a
more open financial and currency system than
Chinas.
"Both nations benefit from having large diasporas.
In Indias case, its a huge source of cash, with
remittances of over $65 billion a year, equal to 4%
of gdp. In China, the benefits are as much in kind
as in cash. Companies owned or managed by
ethnic Chinese from Southeast Asia, Hong Kong,
Taiwan and the US have been large corporate
investors in China, with the capital matched by
transfer of technologies and manufacturing know-
how. This is an ever-renewing remittance, as
money pours in each year to finance projects with
solid long-term rates of return.
"Chinas trump card, though, is its Confucian value
system. Its potency as an economic force is amply
demonstrated by the affluence of Chinas
Confucian neighbors, not just Hong Kong,
Singapore and Taiwan, but South Korea and Japan.
Its impact is measurable as well in the outsized
economic clout of Chinese immigrants in Thailand,
Philippines, Indonesia. Free market capitalism and
Confucianism. Anywhere in the world you find
sustained economic success and rising prosperity,
you will find at least one. In China, they are
entwined in a kind of ideal synthesis.
India vs. China GDP Growth 1960-2010

13
"India, too, has close-knit families and a tradition
of thrift and obedience. Confucianism adds to
these a reverence for education and practical
problem-solving. It contains nothing transcendent,
not much, if any, spiritual guidance for soul-
searchers to make sense of their place in the
cosmos. Honor your ancestors with burnt offerings,
sweep their graves at least once-a-year and theyll
grease the wheels of success in this life.
"The Confucian system hasnt changed much for
two thousand years. One vital adaptation over the
last century, though, was to accept that women
could, and should, play an active role outside the
house, reaching the same educational level as men
and joining the workforce in equal numbers. Here,
India is woefully far behind. Chinas growth has
been on steroids these past twenty years because
its 650 million women have contributed
exponentially more to economic growth and
prosperity than Indias.
"Of the couple hundred stories I wrote while at
Forbes, Im probably proudest of this India cover
story published twenty years ago. It may not seem
like it now, but it was a gamble to suggest back
then under my byline India was about to come out
of its long economic coma. Imagine if instead Id
gone on the record 20 years ago to forecast the
coming economic miracle in Russia, Mexico or
South Africa all countries back then seen by
some to be the next great emerging market.
"I heard afterward the article helped generate
more interest in Indias economic reforms and
ultimately more investment in India by US
multinationals. This grew about 30-fold in the ten
years after the article appeared.
"On a personal level, I made a larger, and I think
even safer bet with my own professional life, to
move to China and start a business here. Yes,
India has English. I work every day in an alien
tongue and in a culture steeped in Confucian
values that play little or no part in my own ethical
code. But, China was, is and shall long remain the
great economic success story of all-time. "

The Big Churn: High
Partner Turnover at PE
Firms in China

Whats the biggest risk in China private
equity investing? Depends who youre asking. If
you ask LPs, the people who provide all the money
that PE firms live off, you will often hear a
surprising answer: turnover at PE firms. Nowhere
else in the PE and VC world do you find so many
firms where partners are feuding, quitting or being
thrown off the bus.
A partnership at a PE firm is meant to be a long-
term fiduciary commitment. In China, it rarely is.
The result is billions of dollars of LP money often
gets stranded, and possibly wasted. Thats because
when a partner leaves, it often creates a bunch of
orphaned investments. The departing partner is
generally the only solid link between the PE firm
and the investee company. Everyone left behind is
harmed the PE firms, the companies they invest
in, and the LPs whose money is trapped inside
these deals.
As the CEO of one of Asias largest and most
professional Limited Partners told us, Before
committing to a new China fund, we spend more of
our time trying to figure out how the partners get
along than just about anything else. Will they hang
on together through the life of the fund? We know
from experience how damaging it is when partners
fall out, when key people leave. We know turnover
can mean we lose everything weve invested. And
yet, we still often get stung.
The PE and VC industry in the US and Europe has
far less churn. A quick look through CFC's Outlook
contact database reveals that almost half the PE
partners we know working in China have changed
firms in the last five years. One reason you dont
see this elsewhere is that partners expect to earn
carried interest on the deals theyve made. If they
leave, they forgo this.

14
Carry is a kind of unvested pay. On paper, its
often quite sizable, and should represent the
majority of a PE partners total compensation, as
well a kind of golden handcuff. The only reason for
partners to leave is they believe they wont get any
of this money, either because of failed deals or,
more commonly, large doubts that the head
partner, the person running the firm, will share the
rewards from successful deals.
Most China PE firms are partnerships in name only.
There is usually one top dog, usually the founder
and rainmaker. This person can unilaterally decide
who stays, who goes, who gets carry and who gets
a lump of coal. Top Dog tends to treat partners like
overpaid, somewhat undeserving hired hands.
So, why have partners at all? Often its because
LPs insist on it, that they want PE and VC firms in
China to be structured like those elsewhere. The
business card says Partner but the attitude,
expectations and level of commitment say
Employee.
Senior staff (VPs, Managing Directors) also
frequently depart. In the US and Europe, you dont
often see that much, since these are the people in
line to become partners, which is meant to be the
crowning achievement of a long successful career
in the trenches. They leave because they dont
believe theyll be promoted, or if they are, that
theyll see any real change in their current status
as wage-earners.
At a party celebrating a recent IPO of a PE-backed
Chinese company, one of those invited was the PE
professional who led the original investment. He
had since left and joined another firm. He laughed
when asked why he would leave before the IPO,
with his old firm certain to earn a big profit on his
deal. I dont know who will get the carry, but I
was sure it wouldnt include me, he explained.
Partners jump ship most often because someone is
offering a higher salary, a higher guaranteed
amount of pay. Their new firm will usually also
offer them carry. Both sides will negotiate fiercely
over the specific terms, what percent with what
hurdle rate. And yet, more often than not, it seems
to be a charade.
From day one, the new partners may already be
thinking about their next career move, how to
trade up. Emblematic of this: here in China, when
PE partners join a new firm, they almost always
refer to it as joining a new platform. Note the
choice of words: platform, not firm.
The LPs acknowledge, of course, that there are
other big risks in China, that individual
investments or even a whole portfolio turns sour.
But, this is a risk inherent in all PE investing
everywhere. High partner turnover is not.

Investors vs. Asset
Managers: Which Path for
China PE?

Assuming the same level of risk, would you
rather make $100 from investing $10 or from
investing $50? Easy, right? Who wouldnt choose
to make ten times your money, rather than just
double it? There is one group. Private equity firms
active in China. At least some of them. They often
care more about the amount they can invest in a
deal than the profits they stand to make.
The illogic at work here is the direct result of some
particular, not very appealing characteristics, of
the PE industry in China. PE firms lately have more
confidence in their ability to raise money than to
invest it profitably by achieving a timely exit. To
raise money, though, a PE firm needs first to
spend most of what it already has. Result: a rush
to get money out the door and parked in deals.
In industry parlance, check size is often more
important than potential risk-adjusted returns. This
is one reason for the recent rash of take private

15
"P-to-P" deals of Chinese companies quoted in the
US. The transactions seem ill-considered. PEs have
invested billions of dollars in such deals but there
is not a single successful example they can point to
of such P-to-P deals done in the US making money
for investors. This must be a PE industry first so
much LP money put at risk against an investment
idea that is totally unproved.
Whos most harmed from focus on check size
over deal quality and prospective returns? Of
course its the LPs whose money is put into these
deals. They want and need high returns, not bigger
deals done using their money to aid PE firms
future fund-raising.
But, Chinese entrepreneurs also suffer in this
environment, because many PE firms now simply
wont look at deals where they cant invest at least
$25mn for around 25% of the company. There are
few deals out there in that size range, meaning
deserving entrepreneurs cant find investors.
The big picture here: PE in China has become more
and more a business dominated by asset managers
not investors. How to tell the two apart? An asset
manager enjoys the comfort and certainty of
making a steady 2% a year managing other
peoples money. The more money they raise, the
more money they keep. Good markets or bad, the
money keeps rolling in.
An investor, on the other hand, is a whole different
animal. They share some DNA with the
entrepreneurs they back. They love the sport of
finding and evaluating deals, spotting where big
money can be made, putting money at risk. When
it works, they make big sums for their investors,
and keep a nice chunk themselves.
Needless to say, LPs give money to PE firms in
hopes they have chosen investors not asset
managers. PE firms know this, of course, and tailor
their money-raising pitch accordingly. They stress
their deal-making prowess, not the fact that over
the life of a typical 10-year fund, an LP will start
with a 20% cumulative loss, because of the typical
annual management fee deductions.
In China, it used to be fairly easy to make money
in PE. But, over the last three years, returns began
to head south. More recently, over the last 18
months, the performance has mainly been dismal,
with few successful deals exiting with big profits.
Its getting harder and harder for LPs to make
money in China PE, after those accumulated
management fees have been deducted.
But, theres a time lag as well as an information
asymmetry at work here. While recent
performance has been, on the whole, lousy, theres
still appetite among LPs to allocate more money to
China. A big reason is that Chinas economy, and
capital markets, are both the second-biggest in the
world. Most LPs are seriously underweight China
and want to change that.
And so we arrive at the current paradoxical
situation, where its still comparatively easier to
collect money to invest in China than to make
money deploying it. Now, of course, PE firms can
only succeed in raising capital if they can point to
some successful past deals. Here too theres an
information asymmetry at work. Many PE firms did
well from 2005-2010, and so their fund-raising
documents emphasize deals done during this era.
But, the game has changed out of all recognition
since then.
Few, if any, PE firms have shown they can
continue to earn investors good money when
markets become less accommodating. Its no
longer possible to play the game of valuation
arbitrage, of investing in China deals at single digit
p/e multiples, and exiting them soon after at 5-10
times higher multiples through an IPO.
Earning a profit on an investment takes
preparation, luck and time. Making money by
convincing people to pay you a fee to manage
theirs, by contrast, is a much simpler proposition,
as well as a no-lose one.
And so the gulf widens between the objectives of
PE firms and the fiduciary responsibilities and
performance goals of the institutions whose money
they manage.

16
This can be a problem everywhere in the PE and
VC industry, as well as more broadly wherever
people get paid to manage assets. (Economists call
this the "Principal-agent dilemma".) But, its
probably especially pernicious in China PE.
The China PE industry is staffed mainly be ex-
investment bankers who by background and
temperament understand more about fee-based,
than performance-based, compensation. Few have
a background of actually managing a company,
investing its capital to produce a return. Without
this first-hand understanding, its far harder as an
investor to plot how to make an operating business
more valuable. The result: PE firms in China will
often opt for an easier path: making money by
raising money from, and managing for, other
financial professionals.

How Beijing Became
Unmanageable: Blowout
Government Spending
Played a Big Role

What if most of what we think about
government spending was wrong? What if
government money causes, rather than
cures, pollution, unaffordable and substandard
housing, impossible traffic, more expensive and
less available healthcare? Sounds impossible, right?
Not if you live in or have traveled to Beijing lately.
The citys now-infamous and perhaps incurable
urban problems are, at least in part, the result of a
deluge of government spending since the onset of
the financial crisis in 2008. Direct central
government funding doubled to over Rmb 14
trillion ($2.2 trillion) over that time. Almost as
much, Rmb 13 trillion ($2.1 trillion), was borrowed
by local governments to finance their spending.
The government money, of course, wasnt meant
to turn Beijing into an unmanageable urban sprawl
with a population larger than every state in the US
except California. In fact, most of the government
stimulus was targeted for big projects outside the
capital. But, in China, the nature of things is that
much of government spending travels on a round-
trip ticket. It is dispensed in Beijing and then a big
part of it eventually returns home. And no, this
isnt all in kickbacks. A large part is from the build
out of a new huge new infrastructure in Beijing to
support, steer and encourage the distribution of
more government cash.
In the last five years, it seems like everyone
rushed to open or expand offices in Beijing, to get
closer to the action: companies of all sizes from all
part of China and the world; governments from the
smallest local hamlet 3,000 kilometers away to
provinces with populations larger than every
country in Western Europe, also staffed up. Result:
commercial and residential real estate prices
skyrocketed to the point now where they are
among the highest anywhere in the world.
More people beget more cars, more cars beget
more traffic, more traffic begets restrictions on the
days-per-week any car can be on the road, which
in turn begets Beijingers buying an extra car to get
around the prohibition. End result: pollution in
Beijing is now substantially caused by auto
emissions, not as in the old days by nearby-
factories burning coal. Many polluting factories
have been shut down, which added to the available
land for development into commercial and
residential property in and around Beijing,
particularly in areas you need a car to get to.
Here are the two charts, showing residential real
estate prices and cars registered in Beijing from
2008 through last year. It's common knowledge
the numbers are underestimated, by quite a bit.
But, they show the trend.

Vehicles Registered Residential Real Estate

17
The torrent of government cash had all kinds of
spillover effects that have altered Beijing
permanently. More restaurants, higher prices,
more wining and dining, leading to prohibitions last
year, as part of the big "anti-corruption" crusade,
on government officials accepting invitations to
party outside the office. This then drives the
behavior underground, so high-end restaurants
empty out, while more expensive and exclusive
members only clubs flourish.
Beijing has morphed from the political capital into
the cash capital of China. Thats attracted a large
group of players to move from Shanghai and Hong
Kong to get a piece. PE funds, private bankers,
lawyers, consultants, so-called guanxi merchants
who arrange access to government officials. We
can count 15 PE professionals we know who left
Shanghai and moved to Beijing in recent years, to
get closer to the action. Only one left. He couldnt
take the crowds, pollution, high cost.
Beijing's precise population is unknown. The official
number if 21.1 million. Some in government say
25 million. Others claim it's closer to 30 million, if
you count more recent migrants living rough, plus
the huge throngs in Beijing for shorter periods,
either for work or pleasure.
Since 2008, far more of Chinas total economic
activity is decided by government bureaucrats in
Beijing. Overall government spending has more
than doubled. Result, more people need to travel
to Beijing more often.
Look at passenger numbers at Beijings Capital
Airport. Between 2008 and 2013, this already
crowded-facility saw passenger numbers increase
by a remarkable 50%. It is, as of March this year,
now the busiest airport in the world, eclipsing
Atlantas Hartsfield. Capital Airport is now breaking
under the load, and so Beijing is about to embark
on building an even larger new airport. This
mammoth $11 billion project by itself could
support a lot of Beijings gdp growth in the coming
few years. But, it will be just the cherry on top.
Beijing has the best hospitals in China, so people
come from all over the country to try to get
admitted for medical treatment. This has led to
price increases and longer waiting times. Equally,
those with a serious grievance about their local
government, or who feel maltreated, will often
gather up their documents go to Beijing to try to
get redress. This trek to Beijing has been around
since the days of the Emperors. As Chinas
government grows in power and economic
clout, and ordinary Chinese have the money to
fight back, those seeking to petition central
government's help increase.
To serve all the new arrivals and visitors, Beijing
continues to expand its Metro system. The average
daily ridership is now 10 million, about triple
Londons, and also triple the amount five years ago
in Beijing. Waits at rush hour to get into some
stations are now so long the government recently
proposed to raise fares. Beijing currently has the
cheapest public transportation of any big city in
China. Some may leave Beijing because Metro
prices are going up. But, more will probably seek
to buy a new car. They will join to queue in the
lottery waiting for permission to buy one. Yes, you
need to win a lottery for the right to pay twice the
price of the same car sold in the US, and can only
legally drive it on Beijing's roads every other day.
By last September, there were 1.6 million people
in Beijing waiting for their number to come up.
How bad is traffic in Beijing. Horror stories abound.
One data point: the manager of a large
telecommunications company reports if he doesnt
now leave his house by 7am, it will take 90
minutes to drive 10 km from his house to his office.
Thats about speed of sedan chairs used to carry
emperor and his cohorts around the Forbidden City.
To be sure, Beijing is not Dhaka. Since 2008, many
aspects of the citys infrastructure have been
upgraded. It is a thoroughly modern city, with
scarcely a trace of either poverty or blight. Thirty
years ago, Bactrian camels were still occasionally
seen on the streets hauling freight. No more.
For first time since 1949, the leader of the country,
Xi Jinping, is Beijing born and bred. Since he was
a boy, Beijings population has about quadrupled,
while China overall has almost exactly

18
doubled. Will he try to shift gears, slow or even
reverse the growth in the city's population? It
won't be easy. Government "stimulus" spending,
once turned on is notoriously hard to scale back in
any serious way. Do so and overall GDP growth will
likely suffer.
In its 3,000 years as China's major urban outpost
on the country's northern perimeter, Beijing has
experienced countless invasions, barbarian pillages,
conquests, uprisings. But, nothing in history has
altered Beijing as deeply, and perhaps
permanently, as five years of bounce-back and
kick-back from $3 trillion in government pump-
priming.

Who Owns & Farms
Chinas Land Remain
Central Questions of
Chinas 5,000 Year-Old
Civilization

When Deng Xiaoping assumed power 36
years ago, 80% of Chinas population was rural,
mainly small-scale peasant farmers. Today, half
the 1.3 billion population is off the farm, living in
cities. Two obvious results: China is over twenty
times richer per capita in dollar terms. And, from a
country with a handful of major cities three
decades ago, China now has 160 cities with a
population of at least one million.
The Chinese governments plan is for another 150
million Chinese to go from farm to city in the next
decade. But even then, there would still be as
many as 300mn too many people living in rural
villages. China, according to estimates weve
read, could be efficiently farmed by as few as
100mn full-time farmers, or 7% of the total
population. In the US, less than 2% of the
population works on farms. They live well. A
farming family in the US now earns on average
$108,000, 53% above the national household
average.
In China, peasants earn on average one-third as
much as urban Chinese. As peasant numbers
decline, the incomes rise of those remaining. A
depopulating countryside, however, wont directly
solve rural Chinas age-old problem: farm plots are
too small and often on uneven terrain. This limits
the use of farm machinery and modern farming
methods. Farm yields remain stubbornly below US
and European levels. This, in turn, means food
imports must rise inexorably. Year by year, China
moves farther away from an often-expressed goal
to increase its food self-sufficiency.
The solutions arent hard to formulate. China needs
fewer and bigger farms with more leveled ground
to permit efficient mechanization. But, achieving
this remains, for now, all but impossible. Part of
the problem is that all rural land in China is owned
by the state, so theres no way for peasants to buy
land from one another. A larger problem is the
adverse impact this would likely have on Chinese
society.
Chinas describes itself, even today, as a ,
nongye daguo, or agricultural great power.
This is in some sense an artifact of history. But, it
also reflects a deeper reality, that most Chinese,
even the most thoroughly urban, still have some
concrete connection to village China. Often this is
through extended family members still engaged in
peasant farming.
More directly, many people living in cities if not
the majority than close to it still hold rural
hukou and so generally have an entitlement to
farm a plot of land in their ancestral village. This
hukou system, though much criticized for depriving
many city-dwelling Chinese of full rights to low-
cost healthcare and schooling, acts as an almost-
universal national insurance plan. Those now long-
removed from farming life still have the comfort of
knowing if things ever got really tough, if they lost
their jobs or the small business they started goes
bust, they could go back to where they or their
parents came from. They always have a place to

19
live and enough land to feed themselves and
scratch out a bare living.
China is the most entrepreneurial place in the
world, which creates huge benefits for everyone
living here, including better products, services and
fast-growing incomes. Small farm plots widely held
is one reason for this. They act as the safety net.
So, creating a more efficient farming system by
giving peasants the right to sell or mortgage the
land they farm or hold title to might ultimately do
more economic harm than good. Chinese
government has so far stalled on major reforms of
peasant land ownership. Instead, city-dwellers are
renting the rights to farm their rural plots to local
peasants who have the energy and ability to
manage larger holdings. The incremental effect is
that average farm size will grow gradually. But, of
course, renting land isnt the same as owning it.
No one will invest in improving the quality of the
land if they are renting it year-by-year. Its not
only efficiency that suffers. The levels of heavy
metal soil contamination is reaching alarming
levels in many areas, especially Hunan Province,
source of 13% of the rice grown in China. Who will
pay to clean up the soil and so improve food safety
in China is a national problem without an obvious
answer.
The price of fruits, vegetables and grains are all
rising in China, lifting peasant incomes. But, so are
cash salaries for low-skilled jobs in cities. Run the
numbers and it still looks to be wiser in many
cases to leave the land. The standard land
measurement in China is the mu, equal to one-
sixth of an acre or about one-twentieth of a
hectare. The income from farming one mu in China
is about equal now to one week of low-pay wages,
for example, the salary for sweeping up factory
floors. Not many peasants own and farm 50 mu.
Travel through rural areas on China's high-speed
rail network and it takes less than a second for the
train to pass a typical small plot of farmed land.
There is rarely anyone one out in the fields.
Thanks to pesticides and chemical fertilizers, far
fewer people are needed to grow food. Every day
people leave the land and will continue to for
decades to come. But, who should own Chinas
land and who should farm it remain the central
questions of Chinas five-thousand year-old
civilization.

China's logistical
nightmare

China may be modeling itself after the wrong
part of the American economy. The money, the
rhetoric and the policies are all focused on trying
to replicate Americas lead in high-technology and
innovation. Instead, China would be long-term
much better off and its citizens enjoy immediate
higher living standards if it copied something far
more mundane from the US, its distribution and
logistics. If Chinas $9 trillion economy has an
Achilles Heel, this is it. It simply costs too much to
get things into consumers hands.
Wholesale layer is piled onto wholesale layer, with
margin and fees extracted at every step. Fixers,
expediters, overlookers all take a cut. Trucks are
too small, tolls too high, warehouses too small,
and road traffic too congested in major cities.
Commercial and retail rents are high, relative to
per capita income level. In China, there is enough
friction in every retail transaction to start a
bonfire.
Logistical costs and bottlenecks are the single
biggest reason why so many goods made in China
are sold at higher prices than in the US. This has
more real-world consequences for average Chinese
consumers than the level of the dollar-Renminbi
exchange rate. It is logistics costs, all the
stickiness and expense of getting products to
market, that is most to blame for holding back the
buying power, and so spending impulses, of

20
Chinese consumers. Middlemen live well in China.
Consumers less so.
It is cheaper, in many cases, to get a product
made in China onto a container ship in Shanghai,
offload it in Long Beach, truck it across the US,
and then stock it on a shelf at a Wal-Mart in
Georgia then it is to put the same product in front
of Chinese consumers in a Wal-Mart in China. High
taxes dont help. Chinas VAT, applied to most
things sold at retail, is set at a higher level than
most sales taxes in the US. Another factor: retail
competition as Americans know it is also largely
absent in China. Stores dont compete much on
price in China. Wal-Mart wont say, but its a fair
assumption its margins in China are at least double
those in the US.
But, high consumer prices in China are mainly the
product of the high handling charges. A simple
example: fruit prices. Most fresh fruit grown in
China costs as much or more in supermarkets here
than the same fruit grown and sold in the US.
Apples sell for around Rmb 6 (95 cents) per pound
and up in China. The apple farmer gets around
Rmb 1 per pound. The rest is liberally spread
among all those standing between apple tree and
one's mouth.
Adjusted for purchasing power, Chinese average
income levels are around 1/6th the USs. So, that
Chinese apple sells for the equivalent, in US terms,
of $6 a pound. That amounts to a lot of money per
apple being shared by people other than the
grower and the eater. How much? Chinese eat a
lot of apples. In fact, almost half of all apples
grown in the world are eaten in China, ten times
more than total US consumption.
We've met the boss of one of Chinas largest apple
shipping and packaging companies, a big player in
the logistical industry. Outside of China, this is a
razor-thin margin business. But, the Chinese apple
shipper has net profit margins well above 10%.
One of the most expensive links in the Chinese
domestic supply chain are road tolls. Chinas are
among the most costly per kilometer traveled
anywhere in the world. Trucks carrying agricultural
products dont pay tolls. Anything else moving
along Chinas highway system pays full freight.
Depending where you are in the country, tolls run
as high as 25 cents a mile for passenger cars.
Trucks pay triple that. It all, of course, ends up
being passed along to consumers.
To amortize the tolls, truckers overload their
vehicles. This burns more fuel, degrades roadways
(justifying still higher tolls), and makes loading and
unloading more time-consuming and so more
costly. According to the boss of a large long-
distance shipping company based in China's
Northwest, his trucks are routinely pulled over by
traffic police and made to pay various on-the-spot
fines. This can double the amount paid in tolls.
Everything about the logistics industry in China
acts as a sponge soaking up consumers cash. The
one exception: Shunfeng Express (). Little
known outside China, Shunfeng Express is Chinas
most successful private shipping and delivery
companies. It alone proves that logistics in China
doesnt need to be wasteful, expensive and
inefficient.
Shunfeng is modeled after Fedex, DHL and UPS,
but operates on a scale, and at prices, that would
be unimaginable to these global giants. Shunfeng
is a secretive outfit. Not much is publicly disclosed.
The founder lives in Hong Kong, but comes
originally from the mainland. It was started in
1993, and according to some media reports, its net
income in 2010 of Rmb 13 billion ($2.1 billion).
That may be a stretch, but Shunfeng is doing a lot
right and deserves whatever profit it keeps.
Shunfeng picks up and delivers documents,
packages and some bulk freight between cities in
China. It charges a fraction of what Fedex or UPS
do in the US.
These US companies are mainly prohibited to
operate in Chinas domestic delivery market. It's
doubtful they would be eager to. For next-day
document delivery within a city, Shunfeng charges
under $2. Delivery to other cities: $3.

21
If you want to move a few kilos of freight,
Shunfeng not only ship it, but will come and
package it for you. That part is free. The shipping
usually works out to less than $5 a kilo.
One of the main reasons Alibabas Taobao has
become so successful in China is that Shunfeng
ships Taobao purchases cheaply and efficiently
across China. Taobao, which operates like a cross
between Amazon Marketplace and eBay, will likely
facilitate transactions worth around USD$100
billion this year. A lot of that will get shipped and
delivered by Shunfeng.
They have an army of delivery guys. Most larger
office buildings in major cities have one
permanently stationed inside. You call for a pickup
and the Shunfeng guy arrives within minutes. Most
letters and packages get moved around by either
electric motorcycle or jet. It leases its own aircraft
to fly stuff around within China.
Shunfeng doesnt do cross-country trucking. This is
one big reason using Shunfeng is so efficient and
so cheap. Anything that moves by truck in China is
going to have multiple hands in the till, and so end
up costing consumers too much.
Shunfeng has achieved its massive scale and now
well-known brand in China without raising capital
from the stock market. They raised their first
round of outside capital last year.
There are few private companies in China we
admire more, and who are doing more to benefit
the average consumer in China. We wish we could
invest.
For the good of every consumer in China,
Shunfeng should continue to grow, continue to
expand the range of what it handles in China. That
will do a lot to unstick Chinas logistical logjam.

The Big Fours Big
Headache in China

Earlier this year, an SEC judge in the US
delivered a spanking to the Big Four accounting
firms, barring their Chinese affiliates for six
months from doing audit work for US-quoted
Chinese companies. To the extent [the Big Four]
found themselves between a rock and a hard
place, the judges decision declares, it is because
they wanted to be there. A good faith effort to
obey the law means a good faith effort to obey all
law, not just the law that one wishes to follow.
Overall, the judges 112-page ruling on the audit
work of the Big Four in China makes for interesting,
and at times damning, reading. It should probably
be required reading for anyone working in Chinese
private equity and capital markets transactions
with Chinese companies. Investments in Chinese
companies worth many tens of billions of dollars
rely, at least to some extent, on the accuracy and
reliability of Big Four audits. That audit bedrock
looks shakier now than it before January 2014.
The Big Four are appealing the decision meaning
that for now at least, they can continue to serve
their US-listed Chinese clients, continue to audit
their accounts, and continue to earn sizable fees
for doing so. If they lose the appeal, they will need
to suspend for six months their main activity in
China. The Big Four have a near-monopoly on
audit work for the over 160 Chinese companies
listed in the US. Will their Chinese clients
permanently go elsewhere? What about the 15,000
people working for the Big Four in China? How will
the firms pay them during the half-year suspension?
How will they spend their working days if not
engaged in audit work?
This much is clear: whatever happens with the
appeal, the reputation and trustworthiness of the
Big Fours work in China has taken a serious
beating. The judges decision is particularly ill-
timed. Chinese companies have only just regained

22
some of the lost trust of US investors, allowing
IPOs to resume.
This dispute between the SEC and the Big Four has
been bubbling away for over two years. It was
triggered by a series of SEC investigations into
serious misbehavior by some Chinese companies
then-quoted in the US fraudulent financial
accounts, incomplete disclosure, faked revenues.
The companies were punished, and their shares
delisted from the US stock exchange. But, what
about the Big Four auditors? Why hadnt they
uncovered and reported their clients misconduct to
the SEC? Were the Big Four in China
careless? Negligent? Or even complicit in these
Chinese companies attempts to mislead US
investors?
This quickly became a focus of the SEC
investigation. To determine if the Big Four audits
were performed thoroughly and in compliance with
US securities laws the SEC asked the Big Four in
China for their audit papers that is, the
complete written documentation showing what
they did and with what level of diligence and
accuracy. The Big Four refused the SEC requests to
hand over the audit papers, saying that to do so
would violate Chinese state secrecy laws.
They used the same argument with the judge. He
rejected it outright. Instead, he says the Big Four
demonstrated gall in flouting the SEC, were
oblivious to some core legal issues, and took a
calculated risk they wouldnt get punished.
Strong stuff.
While the judge doesnt say directly that greed was
a major factor in the Big Fours decision to disobey
SEC orders, it may be fair to make that inference.
Their strategy seems basically having ones cake
and eating it too. They wanted to keep earning big
fees for China audit work, while not fully complying
with US securities laws. In specific cases cited by
the judge, accounting fraud at US-listed Chinese
companies was first brought to light by short-
sellers, rather than by the Big Four audits.
The judges ruling notes the fact that over the last
decade, the Big Four have built very large
businesses in China. KPMG China and Ernst &
Young China both tripled in size from 2004-2012.
PWC grew fastest, increasing its staff four-fold to
over 8,000 people. Such rapid growth is
unprecedented in the recent history of large
accounting firms.
One huge irony here is that the Big Four are
accused by the judge of violating Sarbanes-Oxley.
That law has overall been very good to the Big
Four, since it gave accountants increased
responsibility to police US-listed companies
financial accounts.
The scope of audits increased and with it the fees.
But, when things go wrong, as they have with
quite a number of Chinese quoted companies listed
in the US, the auditors can potentially be held
legally liable.
The Big Four all argued to the judge they should
be treated leniently because if banned, no other
accountants in China have the training and
professionalism to do audit work that meets SEC
standards for investor protection. Any Chinese
company that cant find a new auditor would need
to delist from the US stock exchanges.
The judge dismissed this argument, and helpfully
lists a group of five other accounting firms that
have done audits in China and, unlike the Big Four,
turned over audit papers to the SEC when asked.
Among those named: Grant Thornton, Patrizio &
Zhao.
Some big US multinationals including P&G,
Amazon.com, Apple, The Coca-Cola Company and
Nike, with large revenues and operations in China,
would probably also need to find new Chinese
auditors if the ban is upheld. Investing or
operating a US-owned business in China, never
easy, will become even trickier if the Big Four are
forced to down pencils in China and serve the six-
month SEC suspension.

23
Tiananmen 25 Years
Later: "I was There and I
Was Wrong"
By Peter Fuhrman, Chairman, China First Capital

Twenty-five years ago on the evening on
June 3, 1989, I was standing in the northeast
corner of Tiananmen Square as Chinese soldiers
emerged in large numbers from inside the National
History Museum a short distance away. From
loudspeakers came instructions that all those
gathered in the square should leave in an orderly
way. The Tiananmen Square Protests begun seven
weeks earlier was entering its final brutal phase.
It would be another seven hours or so on the
morning of June 4th before the last of the
demonstrators would be led unharmed out of the
Square. The violence that night occurred elsewhere.
Chinese troops entering the city by road
encountered stiff resistance, particularly to the
west and south of the square. I witnessed some of
this at close quarters the mayhem and loss of life.
I was a reporter at the time. I dont reflect often
on these events, and this is also the first time Ive
written about what I saw there.
Most of what I and so many others thought was
true and inevitable at that time turned out to be
wrong. There was no civil war, no fracturing of the
country, no return to Maoism, no retreat into bitter
isolation, no dying of the universal hope here for a
better life.
China today is an infinitely better, fairer, richer,
more open and freer place than it was in 1989.
This is the reality that too many in the West are
unable or unwilling to see. Their views about China
were cast in concrete that awful night in June 1989.
All they often choose to see are ghosts of
repression and despotism.
So what I have learned these twenty-five
years? Chinas long history, for all its stunning
achievements and millennia of global weight and
prestige, is also etched with pain from war,
famine, civil discord. No single cataclysm could
possibly define its destiny or determine the
countrys future. Not Tiananmen. Not the Cultural
Revolution. Not the civil war that brought the
Communists to power in 1949. Not the Japanese
conquest of the 1930s, nor the Taiping Rebellion
eighty years earlier in which perhaps 30 million
Chinese perished.
Amnesia is what some Western commentators
and authors now choose to call it. I prefer to think
of it as a deep, practical and praiseworthy
resiliency. China is where it is today, at a moment
of prosperity and bright prospects unprecedented
in its history, because most, if not all, of the
country of 1.3 billion willed it there. Through toil.
Through self-reliance and self-improvement.
Through an unshifting focus on bettering their own
lives, and those of their families. And, also through
knowing when and how to bury the past.
Was this made easier because no news about the
Tiananmen protests circulates in official media, and
nothing is taught in schools? Quite likely. But, by
itself, the impact of this was negligible on Chinas
transformation since 1989. The country is now
thirteen times larger, in per capita gdp terms, than
it was then. The improvement in peoples lives
goes beyond the scale of numerical measurement.
It is the largest, most complete and most rapid
uplift in human history.
Yes, some problems from 1989 still remain. China
has polluted air and water, as it did in 1989. It has
corrupt officials. As it did in 1989. Its politics are
now and were then opaque and closed in most
parts to public scrutiny. Then, as now, China
confounds and sometimes infuriates those who
visit it, study it, admire it, or seek to trade with it.
I left Beijing on June 15
th
1989, together with my
oldest and closest friend, who was expelled as an
Associated Press journalist due to alleged links
with student ringleaders. We met as two of a
handful of American students in Nanjing in 1981,
when food was still rationed and China was as poor,
per capita, as India and poorer than just about
everywhere in Africa.

24
I stayed away for many years, moving back almost
five years ago. That friend is also back now in
China, raising his three children in Beijing. He and
I dont see eye to eye on China. Our
interpretations are quite different on what
happened in Tiananmen that night, and the impact
it exerts over todays China. We speak about it
rarely.
Hes writing a history book now on the many ties
that bind the US and China together. He is more
fixated on politics, with intrigues and policy shifts
in Beijing. I care little about that, and far more
about what happens here financially and
economically.

We both feel grateful to live in China now, and in
our own ways, grateful also to hold onto a few
memories of China as it was 33 years ago, and
also on that night in 1989. No amnesia. Some late
middle-aged forgetfulness for sure.
China is not at all like the sad place we expected it
to become when we left Beijing together in 1989.
It is our home. It provides us both with
opportunity, friendship, purpose, careers,
happiness, love, occasional frustrations and, when
we remember to take note, a sense of
astonishment at all weve witnessed, and how
much farther China has come than we ever dared
imagine.
CHINA FIRST CAPITAL

Global Outlook, China-focused investment banking for companies, financial sponsors

Tel: 0755 86590540 Email: ceo@chinafirstcapital.comWebsite: www.chinafirstcapital.com

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