Private Equity and Strategic M&A Transactions in China
A New Dawn: Building Value and Investing for Long-Term Stable Gains


Private Equity and Strategic M&A in China

Turbulence creates opportunity
2008 was a year of extremes in China. Extremes of joy and pride, during the Beijing Olympics. Extremes of sadness and shock following the Sichuan earthquake. Even the climate reached extremes, during China’s crippling winter storms early in 2008. Financially, 2008 was also a year of extremes. The stock markets in Hong Kong, Shanghai and Shenzhen rose strongly in the first months of the year, and IPOs were plentiful. By mid-year, the markets began plunging, and IPOs dried up. By year-end, Shenzhen, Shanghai and Hong Kong were all down 60% for the year. China’s private equity and venture capital investments followed a similar turbulent course, beginning strongly, with over $10 billion invested in Chinese companies in the first half of the years, and then the pace of new investments slowed to a crawl. Governments in China, the USA and around the world intervened in an unprecedented fashion to stabilize the economy and the credit markets. As we enter 2009, there is no longer any doubt that the world economy is in recession. The question now is when will the recovery begin and when will be a good time to begin investing again? I want to offer a personal perspective to our valued relationships, both clients and the private equity firms we work with. As Chairman of China First Capital, Ltd, with over 20 years of experience in the capital markets, private equity and business analytics, I’ve survived my share of business cycles. One example, I was CEO of a California venture capital company during the Dot-Bust years, the last time private equity investing came to a similar standstill. Within two years, deal activity and valuations resumed their upward momentum. My view: the overall investment environment in China remains challenging and the effects of 2008’s turbulence are still being felt. But, 2009 will be a year of unique opportunity for private equity, venture capital and mergers and acquisitions in China. Tough times can be the best time to make money. Here is a broad overview of some of the themes business owners and private equity investors can expect to see in 2009.

Consolidation and “flight to quality”
The Chinese economy is under significant strain as 2009 begins, with growth decelerating, factories closing by the thousands and unemployment rising. Many areas of China’s domestic economy are “over-saturated”, with too many companies competing with small market shares. China is ripe for consolidation.



Private Equity and Strategic M&A in China
fell off sharply during the second half of the year. It remains weak as 2009 begins. Initial Public Offerings Volumes in China & Hong Kong, $bn

In the freely competitive markets, the weakest companies will perish. The stronger competitors will be able to add market share and enjoy the virtuous cycle of increasing volumes lowering unit costs, thus boosting profits that can be reinvested to lower still further costs of production. Chinese consumers will respond as well, and reward with more of their money the better managed companies with the most efficient manufacturing and distribution. Out of this, stronger dominant brands will emerge, and this too will push for greater consolidation. This process is just beginning in China. China’s domestic market is huge, second only to the US. In many vertical markets (including financial services, consumer goods, distribution and logistics, retailing, fashion), each point of additional market share in China can equate to tens of millions of dollars in additional revenue. Chinese companies are still, most often, small-inscale relative to the size of the industries they serve, particularly in areas where private companies, rather than those with partial or complete state-ownership, predominate Strong regional companies will acquire competitors elsewhere in China to become national powerhouses. For investors, the opportunities will be unparalleled to back the Chinese companies that will thrive during this process of consolidation. The winners will be able to increase revenues and profits strongly and sustainably, even in a weak economy.

IPO Activity Grew 500% between 2004-2007

The IPO market is, of course, intimately connected to the performance of the stock market as a whole. When overall stock markets are down, the appetite for new issues is subdued. So, as long as the Hong Kong and Chinese markets remain weak, IPO activity will be very limited. For private equity and venture capital investors, this represents a sea change. Private equity and venture capital firms will need to change their orientation. The opportunities to do shorter-term “pre-IPO” financing are currently far fewer than they were. So, the simple arbitrage of a PE or VC firm buying into a Chinese company at a valuation of 18x and selling out 18 months later in an IPO at 20x are gone. Instead, private equity investors in China need to think more like value investors, and less like arbitrageurs. This means looking for opportunities to deploy capital into good businesses offering high rates of return on that invested capital.

Profit Growth provides platform for reemergence of IPO market
IPOs have provided the most certain and reliable route for successful exit in private equity and venture capital investing in China over the last five years. As this chart shows, activity peaked in 2007. It continued at a high level in early 2008, and then



Private Equity and Strategic M&A in China
Convertible Debt
Financial markets are dynamic creatures. Changing exit strategies and lower valuations (both for public and private companies) are both changing the investment landscape in China. Most private equity and venture capital investments in China up to now have been in ordinary “plain vanilla” equity. Additional capital came in the form of traditional senior bank debt, collateralized by assets or receivables. As 2009 unfolds, there will be an increasing interest – among financiers and the companies they back – in hybrid forms of capital-raising. In particular, convertible debt will play a more prominent role.

Profit growth will provide the platform for the reemergence of the IPO market in China. In practical terms, this means that the focus now of private equity investment should be on improving operational efficiency and profit margins. It’s a financial principle worth emphasizing, especially now in China: valuation is ultimately a function of profitability, not a function of the price an investor will pay for those profits. It’s the “earnings” part of a price-earnings multiple that is key. In just the last five years, price-earnings multiples for recent IPOs have gone from a high of over one hundred, to a low of under five. Sentiment can change dramatically with Chinese shares, and it is likely multiples will recover some of the recent lost ground. When will this happen? Impossible to say. What is clear is that good private equity investors will want to refocus their efforts on investing in Chinese businesses where there is a clear and attainable plan to lift profits and profit margins. The most successful private equity and venture firms over the next few years will be the ones that choose the right companies, invest the proper amount, and add significant value beyond just equity capital. There are multiple ways for private equity and venture firms to add this value: providing to their portfolio companies real expertise on marketing, business development, financial engineering, operational efficiencies, corporate governance, audit, and strategic mergers and acquisitions. Each of these can have a meaningful effect on profitability. The goal is: keep profits growing strongly so that when the stock market recovers and IPOs again become feasible, these companies will get the highest valuation among their peers. In 2009, it’s this focused, value-added work with portfolio companies that will separate good private equity investors from the pack.

Capital Structures for Private Equity Deals in China: 2009

Senior Debt

Convertible Subordinated Debt

Subordinated Debt

Redeemable Preferred


Convertible debt (or mezzanine funding) has a number of concrete advantages. It’s a more flexible form of risk capital than either straight equity or debt, and can be more custom-tailored



Private Equity and Strategic M&A in China

to meet the specific financing needs and cash flows of a strong, but capital-constrained business. From the private equity or venture investor’s standpoint, convertibles take some of the risk off the table – an advantage during times of economic stress. Convertibles usually provide some current income, through interest and principal repayment. They also will have an equity component --- usually in the form of conversion rights or warrants – that in the best cases amplify the return over pure liability finance. For the entrepreneur, convertibles provide the risk capital required, but can be fine-tuned to minimize dilution. The debt is also usually subordinated, not collateralized and comes with fewer covenants than typical bank financing. With all their obvious benefits, convertibles should grow in importance as a financing structure in 2009 in China. There is one glaring downside, though. The flexibility means that a convertible investment is often far more complex than straight equity. Complexity is not particularly welcome. The deal terms need to be understood well by the entrepreneur and negotiated well by his lawyer. Neither has likely had any experience with such clever financial instruments. Result: the funding process slows down. China is, by and large, still at a low altitude on the financial learning curve. Convertibles are nonetheless a good fit for China’s particular circumstances. Good companies are still growing and generating both increased cash flow and increased opportunities for expansion. For the many private equity firms that halted investing months ago at the beginning of the downturn, convertibles are a way to get back in the game, putting their money and their mastery of financial markets to work.

Strategic M&A
Even as IPO activity all but came to a standstill in 2008, China’s mergers and acquisition activity reached an all-time high in 2008, with almost USD$160 billion in deals completed, according to Thomson Reuters. This made China the biggest M&A market in Asia, for the first time ever. This is an important development, and China’s role as Asia’s largest M&A market should continue in 2009, despite the current economic slowdown. The reasons: M&A deals in China will continue to make business and financial sense.

Key Drivers of M&A Activity in China

Enhanced Efficiencies Raise Market Share Domestically or Globally Scale Economies

China’s M&A activity in 2008 was almost equally split between purely domestic and cross-border acquisitions. There is huge scope for growth in both areas. The M&A market, more than IPO activity, tends to holds up well even during sour economic times. Asset prices are down, and the benefits of scale are, if anything, more powerful during economic slowdown. The cheapest way to build market share, at this point in China, will often be to buy it.



Private Equity and Strategic M&A in China
Neither Chinese acquirers nor acquired want to pay much, if anything, for the advisory investment banking service. The result is a typically Chinese “Mexican Standoff”, with neither the investment banks nor the Chinese companies willing to budge. Valuable deals are not getting done because of this, particularly among Chinese SMEs. The investment banks bear much of the blame for this, since they’re locked into a gold-plated fee structure generally unsuited to Chinese commercial realities. This needs to change to keep China’s M&A market moving. Our firm, China First Capital, is now in discussions to begin offering M&A advisory service. It will be tailored, as is our capital-raising work, to meet the needs of private SMEs in China. Strategic M&A deals provide great opportunity for private-equity firms active in China to build the value of their portfolio. Looking ahead, there is a real possibility that China’s M&A market will overtake America’s as the world’s largest.

In many markets in China, companies with cash – or the ability to access private equity capital – will be able to make acquisitions that take advantage of oncein-a-lifetime market opportunities. All M&A transactions have risk. Very often, the planned-for gains in efficiency never materialize from combining two similar businesses. In China, the complexities go above and beyond this. To start, there is due diligence risk – the difficulty of getting accurate financial information about an acquisition target. There is significant management risk as well. Better Chinese companies are usually owned and run by a single strong Chairman/Owner, with scarce management talent around him. In a merger, the boss of the acquired company will often step aside, leaving a big hole in that company’s management, and so making it harder for the acquiring company to integrate its new acquisition.

The Strongest Balance Sheet Wins
The difficult economic environment, in China and indeed worldwide, provides a good opportunity for better Chinese companies to reorient their method of financing capital investment and growth. It’s the optimal time for better Chinese companies to strengthen the equity side of their balance sheets by raising capital – either equity or convertible debt. The capital should be used as a platform to continue to invest and grow. The companies with the strongest balance sheets are going to emerge as the winners. The Chinese companies that can raise equity finance will enjoy a significant financial advantage over competitors, and so be able to gain market share. Adding equity finance lowers a company’s overall cost of capital, and also increases the amount of

Another hurdle: M&A advisory work is a complicated beast in China. Investment banks are often needed to play the central role in identifying target companies, managing due diligence, negotiating price. It’s lucrative work, with hefty upfront retainers and even heftier success fees. All the global investment banks love doing M&A work. The problem is getting someone in China to pay for it.



Private Equity and Strategic M&A in China

capital that can be put to work. Both of these factors equate to a very real competitive advantage. Equity investors, principally private equity and venture firms, will need to change their orientation as well. Private equity and venture investors in China need to think more like traditional “value investors”. This means looking for opportunities to deploy capital (either equity or convertible debt) into good businesses offering high rates of return on that invested capital.

capital to work well, and accelerate profits in 2009 and beyond, valuation will certainly be much higher when the IPO market revives. 2009 will be a year when good Chinese companies with domestic focus can get even better. Markets have a tendency to overshoot, in both directions. A year ago, private equity firms were investing at overly high valuations. Now, the pendulum has swung, and they are often insisting on overly low valuations. Low-ball valuations, in the low single digits, are only going to appeal to Chinese companies with no other financing options, or who foresee problems ahead in their business. Needless to say, they will try (and often succeed) to keep those problems hidden from a private equity firm considering an investment. Is deception and investment fraud more prevalent in China? Circumstantial evidence would suggest so. Fraud and due diligence failures are probably the biggest career threat to a private equity or venture investor working in China. Many of the most fundable Chinese companies, from a private equity perspective, have comparatively thin capitalization. Growth has been financed through retained earnings and bank debt. Official Chinese statistics show that 63% of investment in China last year was financed by what are called "internally generated" funds, which include retained profits. That's up from just below 50% a decade ago.

Chinese balance sheets must strengthen

The injected capital is then used by these Chinese businesses to expand output, lower unit costs, gain market share, and so expand both profits and profit margins. Build profits and valuation will take care of itself. For the Chinese businesses that put equity

Private equity capital can thus have a multiplier effect on good businesses, both by increasing capital available for investing in growth and by providing a stronger cushion for increased bank borrowing.



Private Equity and Strategic M&A in China

In conclusion, 2009 will be a crucial time for many Chinese businesses, private equity and venture firms to focus on strategic planning. While some companies try to preserve enough liquidity to survive the year, other companies will take advantage of once in-a-lifetime opportunities to grow via equity financing and acquisitions. To accomplish this, private equity capital will be a preferred way for SME owners to fund growth. While some Chinese businesses will have to hunker down to survive, others will become driving forces for consolidation, positioning them to outperform over the medium and long-term. In 2009, private Chinese companies with defensible and unique customer bases will be hot commodities among strategic private equity and venture capital investors alike. We expect 2009 to exhibit a “flight to quality” phenomenon where companies with unique models and strong management will achieve premium valuations. Defensible niche markets were among the few safe shelters from the economic storm in 2008. In 2009, private Chinese companies with defensible and unique customer bases or brands will be hot commodities among strategic and financial investors alike.

For example, in the fourth quarter of 2008, China First Capital represented Kehui International, a leading Chinese manufacturer of coated aluminum and copper wire, in a $10 million growth capital equity financing with one of the top tier private equity firms active in China.



Private Equity and Strategic M&A in China

In 2009, China should rightly be among the most attractive – and active – private equity investment markets in the world. Private Equity and venture firms are still able to access new capital for deployment in China. There’s less interest among limited partners in providing new capital to other parts of the world. In addition, China’s National Council for Social Security’s enormous public pension fund announced plans to invest as a limited partner in several of China’s domestic private equity funds. Overall, the amount of liquidity available for investing in private equity deals in China is so huge that hundreds of millions of dollars in new investments will almost certainly get done in 2009. Many of the private equity firms we work with are expecting to invest more in 2009 than in 2008, though

most of that will likely come during the second half of the year. When uncertainty prevails, as it does now in 2009, opportunity is usually at its highest. This is a fact known well by both the best entrepreneurs and the private equity firms that back them. The pathways to success in China are fewer and narrower than in recent years. However, for the entrepreneurs and private equity investors that can navigate their way in 2009, this will be a year of substantial opportunity and profit.

Peter Fuhrman, Chairman, China First Capital


At China First Capital, we are focused on two primary businesses – providing strategic financial advice and raising investment capital for a select group of China’s most innovative and high-growth SME companies. We are a trusted partner to our clients and a respected source of quality deal flow for private equity investors.

For more information, please contact:
Peter Fuhrman
China First Capital, Ltd. Email: peter@chinafirstcapital.com Telephone China: +86 1588 929 1362 Telephone USA: +1 310 709 3642
China First Capital, Ltd. Room 4203 Jinzhonghuan Business Building Futian, Shenzhen

Los Angeles
China First Capital, Ltd. 139 Gretna Green Los Angeles, CA 90049

Website: www.chinafirstcapital.com Blog: www.chinafirstcapital.com/blog

© China First Capital Ltd. 2009

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