2009

Private Equity and Strategic M&A

Transactions in China
A New Dawn: Building Value and Investing for Long-Term
Stable Gains
 2009 Private Equity and Strategic M&A in China
Overview

Turbulence creates opportunity
2008 was a year of extremes in China. Extremes of joy
and pride, during the Beijing Olympics. Extremes of
sadness and shock following the Sichuan earthquake.
Even the climate reached extremes, during China’s
crippling winter storms early in 2008.
Financially, 2008 was also a year of extremes. The
stock markets in Hong Kong, Shanghai and Shenzhen
rose strongly in the first months of the year, and IPOs
were plentiful. By mid-year, the markets began
plunging, and IPOs dried up. By year-end, Shenzhen,
Shanghai and Hong Kong were all down 60% for the
year.
China’s private equity and venture capital
investments followed a similar turbulent course,
beginning strongly, with over $10 billion invested in
Chinese companies in the first half of the years, and
then the pace of new investments slowed to a crawl.
Governments in China, the USA and around the
world intervened in an unprecedented fashion to
stabilize the economy and the credit markets. As we
enter 2009, there is no longer any doubt that the
world economy is in recession.
The question now is when will the recovery begin and
when will be a good time to begin investing again? I
want to offer a personal perspective to our valued
2
relationships, both clients and the private equity firms
we work with. As Chairman of China First Capital,
Ltd, with over 20 years of experience in the capital
markets, private equity and business analytics, I’ve
survived my share of business cycles. One example, I
was CEO of a California venture capital company
during the Dot-Bust years, the last time private equity
investing came to a similar standstill. Within two
years, deal activity and valuations resumed their
upward momentum.
My view: the overall investment environment in
China remains challenging and the effects of 2008’s
turbulence are still being felt. But, 2009 will be a year
of unique opportunity for private equity, venture
capital and mergers and acquisitions in China. Tough
times can be the best time to make money.
Here is a broad overview of some of the themes
business owners and private equity investors can
expect to see in 2009.

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

In the freely competitive markets, the weakest fell off sharply during the second half of the
companies will perish. The stronger competitors year. It remains weak as 2009 begins.
will be able to add market share and enjoy the
virtuous cycle of increasing volumes lowering
unit costs, thus boosting profits that can be re- Initial Public Offerings Volumes in
invested to lower still further costs of China & Hong Kong, $bn
production.

Chinese consumers will respond as well, and

reward with more of their money the better
managed companies with the most efficient
manufacturing and distribution. Out of this,
stronger dominant brands will emerge, and this
too will push for greater consolidation.

This process is just beginning in China. China’s

domestic market is huge, second only to the US.
In many vertical markets (including financial
services, consumer goods, distribution and
logistics, retailing, fashion), each point of
additional market share in China can equate to
tens of millions of dollars in additional revenue. IPO Activity Grew 500% between 2004-2007

Chinese companies are still, most often, small-in-

scale relative to the size of the industries they
serve, particularly in areas where private
companies, rather than those with partial or
complete state-ownership, predominate Strong
regional companies will acquire competitors
elsewhere in China to become national
powerhouses.
For investors, the opportunities will be
unparalleled to back the Chinese companies that
will thrive during this process of consolidation.
The winners will be able to increase revenues
and profits strongly and sustainably, even in a
weak economy.

Profit Growth provides platform for
reemergence of IPO market
IPOs have provided the most certain and reliable
route for successful exit in private equity and
venture capital investing in China over the last
five years.
As this chart shows, activity peaked in 2007. It
continued at a high level in early 2008, and then
The IPO market is, of course, intimately connected to
the performance of the stock market as a whole.
When overall stock markets are down, the appetite
for new issues is subdued. So, as long as the Hong
Kong and Chinese markets remain weak, IPO activity
will be very limited.
For private equity and venture capital investors, this
represents a sea change.
Private equity and venture capital firms will need to
change their orientation. The opportunities to do
shorter-term “pre-IPO” financing are currently far
fewer than they were. So, the simple arbitrage of a PE
or VC firm buying into a Chinese company at a
valuation of 18x and selling out 18 months later in an
IPO at 20x are gone.
Instead, private equity investors in China need to
think more like value investors, and less like
arbitrageurs. This means looking for opportunities to
deploy capital into good businesses offering high
rates of return on that invested capital.

3
 2009 Private Equity and Strategic M&A in China

Profit growth will provide the platform for the
reemergence of the IPO market in China. In practical
terms, this means that the focus now of private equity
investment should be on improving operational
efficiency and profit margins.

Convertible Debt
Financial markets are dynamic creatures.
Changing exit strategies and lower valuations
(both for public and private companies) are both
changing the investment landscape in China.

It’s a financial principle worth emphasizing, Most private equity and venture capital
especially now in China: valuation is ultimately a investments in China up to now have been in
ordinary “plain vanilla” equity. Additional
function of profitability, not a function of the price an
capital came in the form of traditional senior
investor will pay for those profits. It’s the “earnings” bank debt, collateralized by assets or receivables.
part of a price-earnings multiple that is key. In just
the last five years, price-earnings multiples for recent As 2009 unfolds, there will be an increasing
IPOs have gone from a high of over one hundred, to a interest – among financiers and the companies
low of under five. they back – in hybrid forms of capital-raising. In
particular, convertible debt will play a more
prominent role.
Sentiment can change dramatically with Chinese
shares, and it is likely multiples will recover some of
the recent lost ground. When will this happen?
Capital Structures for Private Equity
Impossible to say. What is clear is that good private
Deals in China: 2009
equity investors will want to refocus their efforts on
investing in Chinese businesses where there is a clear
and attainable plan to lift profits and profit margins.
The most successful private equity and venture firms Senior Debt
over the next few years will be the ones that choose
the right companies, invest the proper amount, and
add significant value beyond just equity capital.
Convertible
Subordinated
There are multiple ways for private equity and Subordinated
Debt
venture firms to add this value: providing to their Debt
portfolio companies real expertise on marketing,
business development, financial engineering,
operational efficiencies, corporate governance, audit,
and strategic mergers and acquisitions.

Each of these can have a meaningful effect on Redeemable

profitability. The goal is: keep profits growing
strongly so that when the stock market recovers and
IPOs again become feasible, these companies will get
the highest valuation among their peers.
In 2009, it’s this focused, value-added work with
portfolio companies that will separate good private
equity investors from the pack.
Equity
Preferred
Convertible debt (or mezzanine funding) has a
number of concrete advantages. It’s a more
flexible form of risk capital than either straight
equity or debt, and can be more custom-tailored

4
 2009 Private Equity and Strategic M&A in China

to meet the specific financing needs and cash
Strategic M&A

flows of a strong, but capital-constrained
business.
From the private equity or venture investor’s
standpoint, convertibles take some of the risk off
the table – an advantage during times of
economic stress. Convertibles usually provide
some current income, through interest and
principal repayment. They also will have an
equity component --- usually in the form of
conversion rights or warrants – that in the best
cases amplify the return over pure liability
finance.
For the entrepreneur, convertibles provide the
risk capital required, but can be fine-tuned to
minimize dilution. The debt is also usually
subordinated, not collateralized and comes with
fewer covenants than typical bank financing.
Even as IPO activity all but came to a standstill in
2008, China’s mergers and acquisition activity
reached an all-time high in 2008, with almost
USD$160 billion in deals completed, according
to Thomson Reuters. This made China the biggest
M&A market in Asia, for the first time ever.
This is an important development, and China’s role as
Asia’s largest M&A market should continue in 2009,
despite the current economic slowdown. The reasons:
M&A deals in China will continue to make business
and financial sense.
Key Drivers of M&A Activity in China

With all their obvious benefits, convertibles

should grow in importance as a financing
structure in 2009 in China. Enhanced Efficiencies
There is one glaring downside, though. The Raise Market Share
flexibility means that a convertible investment is
often far more complex than straight equity. Domestically or Globally
Complexity is not particularly welcome. The
deal terms need to be understood well by the Scale Economies
entrepreneur and negotiated well by his lawyer.
Neither has likely had any experience with such
clever financial instruments. Result: the funding
process slows down.

China is, by and large, still at a low altitude on

the financial learning curve.
Convertibles are nonetheless a good fit for
China’s particular circumstances. Good
companies are still growing and generating both
increased cash flow and increased opportunities
for expansion.
For the many private equity firms that halted
investing months ago at the beginning of the
downturn, convertibles are a way to get back in
the game, putting their money and their mastery
of financial markets to work.
China’s M&A activity in 2008 was almost equally split
between purely domestic and cross-border
acquisitions. There is huge scope for growth in both
areas. The M&A market, more than IPO activity,
tends to holds up well even during sour economic
times. Asset prices are down, and the benefits of scale
are, if anything, more powerful during economic
slowdown.
The cheapest way to build market share, at this point
in China, will often be to buy it.

5
 2009 Private Equity and Strategic M&A in China
In many markets in China, companies with cash – or
the ability to access private equity capital – will be
able to make acquisitions that take advantage of once-
in-a-lifetime market opportunities.
All M&A transactions have risk. Very often, the
planned-for gains in efficiency never materialize from
combining two similar businesses.
In China, the complexities go above and beyond this.
To start, there is due diligence risk – the difficulty of
getting accurate financial information about an
acquisition target.
There is significant management risk as well. Better
Chinese companies are usually owned and run by a
single strong Chairman/Owner, with scarce
management talent around him. In a merger, the boss
of the acquired company will often step aside, leaving
a big hole in that company’s management, and so
making it harder for the acquiring company to
integrate its new acquisition.
Another hurdle: M&A advisory work is a complicated
beast in China. Investment banks are often needed to
play the central role in identifying target companies,
managing due diligence, negotiating price. It’s
lucrative work, with hefty upfront retainers and even
heftier success fees. All the global investment banks
love doing M&A work. The problem is getting
someone in China to pay for it.
6
Neither Chinese acquirers nor acquired want to pay
much, if anything, for the advisory investment
banking service. The result is a typically Chinese
“Mexican Standoff”, with neither the investment banks
nor the Chinese companies willing to budge. Valuable
deals are not getting done because of this, particularly
among Chinese SMEs.
The investment banks bear much of the blame for
this, since they’re locked into a gold-plated fee
structure generally unsuited to Chinese commercial
realities. This needs to change to keep China’s M&A
market moving. Our firm, China First Capital, is now
in discussions to begin offering M&A advisory
service. It will be tailored, as is our capital-raising
work, to meet the needs of private SMEs in China.
Strategic M&A deals provide great opportunity for
private-equity firms active in China to build the value
of their portfolio.
Looking ahead, there is a real possibility that China’s
M&A market will overtake America’s as the world’s
largest.

The Strongest Balance Sheet Wins
The difficult economic environment, in China and
indeed worldwide, provides a good opportunity for
better Chinese companies to reorient their method of
financing capital investment and growth.
It’s the optimal time for better Chinese companies to
strengthen the equity side of their balance sheets by
raising capital – either equity or convertible debt. The
capital should be used as a platform to continue to
invest and grow. The companies with the strongest
balance sheets are going to emerge as the winners.
The Chinese companies that can raise equity finance
will enjoy a significant financial advantage over
competitors, and so be able to gain market share.
Adding equity finance lowers a company’s overall
cost of capital, and also increases the amount of
 2009 Private Equity and Strategic M&A in China
capital that can be put to work. Both of these factors
equate to a very real competitive advantage.
Equity investors, principally private equity and
venture firms, will need to change their orientation as
well. Private equity and venture investors in China
need to think more like traditional “value investors”.
This means looking for opportunities to deploy
capital (either equity or convertible debt) into good
businesses offering high rates of return on that
invested capital.
Chinese balance sheets must strengthen
The injected capital is then used by these Chinese
businesses to expand output, lower unit costs, gain
market share, and so expand both profits and profit
margins. Build profits and valuation will take care of
itself. For the Chinese businesses that put equity
7
capital to work well, and accelerate profits in 2009
and beyond, valuation will certainly be much higher
when the IPO market revives.
2009 will be a year when good Chinese companies
with domestic focus can get even better.
Markets have a tendency to overshoot, in both
directions. A year ago, private equity firms were
investing at overly high valuations. Now, the
pendulum has swung, and they are often insisting on
overly low valuations.
Low-ball valuations, in the low single digits, are only
going to appeal to Chinese companies with no other
financing options, or who foresee problems ahead in
their business. Needless to say, they will try (and
often succeed) to keep those problems hidden from a
private equity firm considering an investment. Is
deception and investment fraud more prevalent in
China? Circumstantial evidence would suggest so.
Fraud and due diligence failures are probably the
biggest career threat to a private equity or venture
investor working in China.
Many of the most fundable Chinese companies, from
a private equity perspective, have comparatively thin
capitalization. Growth has been financed through
retained earnings and bank debt.
Official Chinese statistics show that 63% of
investment in China last year was financed by what
are called "internally generated" funds, which include
retained profits. That's up from just below 50% a
decade ago.
Private equity capital can thus have a multiplier effect
on good businesses, both by increasing capital
available for investing in growth and by providing a
stronger cushion for increased bank borrowing.
 2009 Private Equity and Strategic M&A in China

Summary

In conclusion, 2009 will be a crucial time for many

Chinese businesses, private equity and venture firms
to focus on strategic planning. While some
companies try to preserve enough liquidity to survive
the year, other companies will take advantage of once
in-a-lifetime opportunities to grow via equity
financing and acquisitions. To accomplish this,
private equity capital will be a preferred way for SME
owners to fund growth.
For example, in the fourth quarter of 2008, China First
Capital represented Kehui International, a leading
Chinese manufacturer of coated aluminum and
copper wire, in a $10 million growth capital equity
financing with one of the top tier private equity firms
active in China.

While some Chinese businesses will have to hunker

down to survive, others will become driving forces
for consolidation, positioning them to outperform
over the medium and long-term.

In 2009, private Chinese companies with defensible

and unique customer bases will be hot commodities
among strategic private equity and venture capital
investors alike. We expect 2009 to exhibit a “flight to
quality” phenomenon where companies with unique
models and strong management will achieve
premium valuations.

Defensible niche markets were among the few safe

shelters from the economic storm in 2008. In 2009,
private Chinese companies with defensible and
unique customer bases or brands will be hot
commodities among strategic and financial investors
alike.

8
 2009 Private Equity and Strategic M&A in China
In 2009, China should rightly be among the most
attractive – and active – private equity investment
markets in the world. Private Equity and venture
firms are still able to access new capital for
deployment in China. There’s less interest among
limited partners in providing new capital to other
parts of the world.
In addition, China’s National Council for Social
Security’s enormous public pension fund announced
plans to invest as a limited partner in several of
China’s domestic private equity funds.
Overall, the amount of liquidity available for
investing in private equity deals in China is so huge
that hundreds of millions of dollars in new
investments will almost certainly get done in 2009.
Many of the private equity firms we work with are
expecting to invest more in 2009 than in 2008, though
9
most of that will likely come during the second half of
the year.
When uncertainty prevails, as it does now in 2009,
opportunity is usually at its highest. This is a fact
known well by both the best entrepreneurs and the
private equity firms that back them.
The pathways to success in China are fewer and
narrower than in recent years. However, for the
entrepreneurs and private equity investors that can
navigate their way in 2009, this will be a year of
substantial opportunity and profit.
Peter Fuhrman, Chairman, China First Capital
At China First Capital, we are focused on two primary businesses – providing
strategic financial advice and raising investment capital for a select group of
China’s most innovative and high-growth SME companies.

We are a trusted partner to our clients and a respected source of quality deal flow
for private equity investors.

For more information, please contact:

Peter Fuhrman
China First Capital, Ltd.
Email: peter@chinafirstcapital.com
Telephone China: +86 1588 929 1362
Telephone USA: +1 310 709 3642

Shenzhen
China First Capital, Ltd.
Room 4203
Jinzhonghuan Business Building
Futian, Shenzhen

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

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

© China First Capital Ltd. 2009