By: Steve Dickinson

This post is part I of a two part series on why investing in Chinese companies can be so different than investing in Western companies.  In this first part, I address how the way Chinese companies typically view investment is so different from that in the West.  In Part two, I will talk about how this differing view so often impacts Chinese joint venture deals.

I often write and talk about how China’s lack of intellectual property protections stems in part for its contempt for the intangible. As an extension of this attitude, China also has what I would call a contempt for investment. For the Chinese, work is generally all that counts. Investment has no permanent value and it tends to be treated like a loan. Once the investment is repaid, the investor is expected to depart and allow the executives who run the company to receive all future rewards. Investors that insist on sticking around to earn a return on their investment are considered to be fundamentally dishonest. Since the investor is operating in bad faith, it is perfectly acceptable for the Chinese company owner to use extra-legal methods to get rid of the investor that overstays its welcome.

This attitude explains one reason why investment in Chinese companies is so difficult. Take the typical venture capital portfolio. The typical venture capital investor is not expecting that every investment will result in a substantial return. Instead, it hopes that one investment of many will score big, resulting in a pay-off that compensates for the relative failure of other investments in the portfolio.

It is difficult to make this approach work in China. The Chinese side is quite happy to accept venture investment in a project that fails. When the project fails, the investment is lost, but the effort of the founders is also lost. As far as the Chinese side is concerned, both sides lost the same amount and they feel no need to compensate the investor for its losses. In fact, the entrepreneur usually believes the loss of its time and effort is a much greater loss than the loss of the investor. After all, the investor only lost money, which can be replaced. The time and effort of a young entrepreneur cannot be replaced. This loss is therefore much more tragic that the mere loss of money.

On rare occasions, however, the project will work and the venture will succeed. In that setting, the entrepreneur founders will expect that the investor will be happy with receiving a return equal to its investment plus a small amount of profit roughly equivalent to the interest it would have earned on its money. When the founders learn that the investors intend to ride the project to the very end, reaping the majority of the financial benefit, the founders believe that they have been tricked. Their work is the entire value of the company. How can it be justified for the investor to stick around and reap the rewards when the investor has done no work? No one expects their banker to continue to demand payments after the loan has been repaid.  In fact, such a demand from a lender would be seen as fundamentally wrong. The same is often seen to apply to an investor. Since the investor’s continuing demand for payment seems fundamentally wrong, the founders will work to eject the investor in some way, even if this is actually damaging to the company. The fact that this attitude is completely contrary to current Chinese law is irrelevant. The attitude is deep-seated and seems to pre-empt any consideration of what is provided for in China’s legal system.

This attitude makes private equity difficult to do in China. I am often challenged when I say there really is no domestic private equity in China. Critics point out the large number of funds that are called “private equity funds” that operate all over China. However, when examined, these funds seldom resemble what we call private equity in the United States. The Chinese funds are more like what we would call “short money lenders.” They lend to a project at high rates of interest. They take their capital and interest and then leave. They usually do not attempt to enter into any kind of a long-term arrangement with their investment targets. This is because they fully understand the basic principal: loans are acceptable, even at high rates of interest. Equity investment is not. Work counts, but investment does not. Think communism.

What are you seeing out there?

The South China Post did a story today on China’s having used its antitrust law to block Coke’s purchase of Huiyuan. The article is entitled, “China raises chills as Coke bid bottled up,” and it talks about whether the blocking of this deal will signal the death of foreign private equity investments in China.
My view is that it absolutely positively will not. In fact, a private equity company contacted me today regarding its desire to purchase a relatively small Chinese niche food company. They asked whether I thought the Coke deal would have any impact on their purchase and I predicted it would not. I told them I thought the company it was seeking to buy was way too regionalized, way too small, and way too insignificant in China’s grand scheme of things for their to be any linkage at all with Coke’s failed deal.
The South China Post hints otherwise, but I attribute that to same-day overreaction:
The article makes the requisite mention of how “US private equity firm Carlyle Group” was unable to buy a controlling stake in tractor parts maker Xugong “after three years of bureaucratic hold-ups” after “Chinese media raised eyebrows abroad by claiming repeatedly that Xugong was a ‘strategic’ national business.” It then quotes Tang Hao of H&J Vanguard Consulting Group saying foreign investors had thought juice was “not a sector that involved economic or national security issues.”
CLB’s own Steve Dickinson is then extensively quoted:

Steve Dickinson, a partner at US law firm Harris Bricken who has advised foreign investors in China since 1979, said the deal provided false hopes Beijing was opening up to foreign buyers.
“After the decision, I think leveraged buyout funds that have set up in Hong Kong will go home,” he said.
International buyout funds with local offices include US giant Blackstone Group and Europe’s largest buyout house, Permira, as well as Carlyle. Blackstone posted a US$1.33 billion loss last year.
“It’s anyone’s guess whether those large funds will stay [in China] or, given the problems back home, just focus on the US and Europe,” said Simon Littlewood, the chief executive of venture capital firm London Asia Capital.
* * * *
Some foreign investors may treat the Coca-Cola setback as a one-off decision. “It may be that lawyers realise after analysing the decision that, in substance, there is a very meaningful market share Coke could gain,” the China head of a western buyout house said.
Andrew Pawley, a corporate finance director at accountancy Baker Tilly, added: “No one talks about abandoning the US if a takeover fails there.”
And foreign private equity firms have been increasing investment on the mainland, with deal values rising from US$2.7 billion in 2007 to US$5.04 billion last year, according to Dealogic.
However, Mr Dickinson cautioned these were mostly small investments in obscure companies.
“China, fundamentally, 100 per cent discourages foreigners from entering the market and there are only three conditions China will permit,” he said. “Either the company is too small for the government to care about, or it is troubled and the foreign purchaser has agreed to improve the business, or the foreign company takes a minority stake and there is a transfer of technology or expertise or access to foreign markets.
“If you don’t fit into one of these three categories you can’t do mergers or acquisitions in China and that’s the end of it.”

Enough with the death knell pronouncements. Foreign private equity investments in China is not going to die, but it will need to modify. Wise foreign private equity firms are going to need to focus on the types of deals that have a real potential to work in China. China will accept the following sorts of foreign deals:
— Foreigners are permitted to purchase small Chinese companies that the central government is not interested in managing.
— Foreigners are permitted to purchase large, state-owned enterprises that suffer from financial difficulty, provided the foreign investor agrees to restructure the purchased company.
— Foreigners are permitted to purchase non-majority interests in strong, successful Chinese companies, but only if there is some added benefit, such as transfer of technology, advanced management or access to foreign markets.
Additionally, foreign private equity firms remain free to invest in foreign companies that are in China already as a Wholly Foreign Owned Entity (WFOE) or a Joint Venture (JV) or to invest in those foreign companies planning to go into China in some way other than by purchasing a large financially viable Chinese company.
For more on China’s denial of Coke’s purchase of Huiyuan, check out the post we did earlier today on this same topic, “China Rejects Coke Deal. We Told You All This Long Ago.
UPDATE: in a post entitled, “Coke, Huiyuan and the audiences that matter,” [link no longer exists] ImageThief does a great job explaining the public relations aspect of this and any other large foreign deal in China. Its summation: “So here it is in plain language: If you’re a large foreign firm taking over a Chinese firm, prepare to be flogged in public. And prepare for it before you announce your acquisition.” True.

Project Alpha just posted the transcript from a very enlightening panel discussion on private equity/venture capital in China. The discussion was at JP Morgan’s recent China conference in Beijing. I attended this discussion and found it very informative. The discussion was between Robert Theleen (CEO, ChinaVest); Joel Kellman (Managing Partner, Granite Global Ventures), and Brandon Lin (Partner, SAIF Partners).

All three of the panelists have done big deals in China and all three did a great job conveying what it takes to succeed as a VC there. If you have an interest in China private equity/venture capital investing, you absolutely should read the transcript.

Interesting post over at the Managing the Dragon blog on the differences between private equity investing in the United States and in China. The post is aptly entitled, “Private Equity with Chinese Characteristics,” and it nicely sets forth how private equity companies like Carlyle, Blackstone and KKR are having to modify their investing methods to conform to Chinese laws and reality:

Beyond the fact that they represent minority stakes, the investments by Blackstone and KKR are very different than those typically made by these firms in the United States and Europe, reflecting their strong desire to find some way to invest in the China market. First off, a few board seats may come with a minority interest, but not the management control which both Blackstone and KKR would insist upon in the United States. Secondly, the investments are unleveraged and are being made with all equity. In the United States, a company’s shares are purchased with a relatively small amount of equity plus a large amount of debt that is based solely on the borrowing power of the company itself. In the United States, buying a company is like buying a house with some savings and a mortgage. In China, it is like buying an apartment with all savings and no mortgage.

Will this work?

The always insightful knowledge@Wharton site recently posted an article, entitled, “China or India, Which is the Better Long-term Investment for Private Equity Firms” and concluded — drum roll please — the two countries were essentially tied:

At first glance, India might not seem the safer bet, with its pitted roadways, tainted water and visible, widespread poverty. Yet those outward signs obscure solid underpinnings for economic growth, including a democratic government, a strong education system, widespread knowledge of English and a deep pool of expatriates experienced in Western businesses, according to Wharton faculty and experts in emerging market private equity.

Cheap labor and foreign direct investment have made China the world’s manufacturing powerhouse under a government that has embraced Western-style capitalism. China has provided spectacular private-equity returns in recent years, but, the experts note, weaknesses in China’s legal system and the possibility of political instability remain concerns for investors.

“Clearly there’s enormous private-equity opportunities in both countries,” says Wharton finance professor Jeremy Siegel.

The article does a very good job distilling the views of various India and China experts and enunciating the differences in the two countries’ investment climates.  I found the discussion on the two countries’ legal system particularly interesting:

One stumbling block has been property rights. While the Indian legal system offers more protection of property rights than China, it does not do so with great speed, said Krishnaswami. “India has exceptional property laws,” he said, “but if you have to enforce them you’re dead.” [Mukund] Krishnaswami, managing director of Krilacon Group, an investment firm based in New York and Philadelphia] said a court case takes seven to 10 years to complete. Bankruptcies can take three to four years.

Freeman said in this environment local partnerships are crucial. “You really have to know who you are getting into business with. If the locals don’t have confidence in the local legal system, it’s crazy to think that foreigners will,” he said. “Local market expertise is critical. To be successful you can’t overlay your U.S. or Western European private equity experience in these markets.”

The same holds true in China.  Though there is tremendous value in having a good contract, even in China, and though I have often stated that China’s courts are fairer (particularly at the higher levels) than widely credited, the courts are still to be avoided if at all possible.

Mr. Krishnaswami’s advice for avoiding India’s courts by doing business with the right people holds true with equal force for those doing business in China.  I would add to his advice, however, by suggesting that even if you know with whom you are doing business, you should still have a written agreement just in case.