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 [email protected]

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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


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


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


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


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.


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,


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


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


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.


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


"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


"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.


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


"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.


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


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


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


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


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.


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


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.


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 15th 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.


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: [email protected]: www.chinafirstcapital.com

China Private Equity Capital Markets 2014, Research report from China First Capital

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Transcript of China Private Equity Capital Markets 2014, Research report from China First Capital