Nothing ventured…

China's private enterprises have huge potential but they lack funds. Investors able to supply capital will unlock a vast reservoir of pent-up demand, writes Francis Bassolino.

Until now, foreign direct investment (FDI) has been the only viable vehicle for direct equity participation in mainland Chinese markets. Over the coming decade, however, this situation will change. Portfolio investments – funds targeting particular industries or regions – will far outstrip FDI.

Portfolio investments will grow for two reasons. First, there is tremendous demand for venture capital services. China has technical skills but lacks capital, efficient managerial structures and the marketing and financial skills to support modern corporations capable of implementing global strategies. Venture capital firms can provide these structures and skills, adding significant value and generating profit. In addition, the Chinese people will rapidly achieve disposable income levels that will create significant market segments, generating opportunities for high growth in select markets.

The other reason is a shortage of available financing. China has one of the highest savings rates in the world – 35 per cent of personal income – and the largest stockpile of foreign reserves, US$260bn. Although many citizens are avid stock market participants, much of their wealth cannot efficiently or legally access capital markets, private or public. Given so few alternatives, people put their money in inefficient bank deposits, which account for more than half of savers' net wealth.

The banks, however, are very poor lenders, with up to 50 per cent of their lending currently tied up in nonperforming loans, according to some estimates. Therefore, although there is a steady supply of funding, the banks are very inefficient at allocating capital – leading to a mismatch between the suppliers of capital and those who need it most.

While world capital markets are willing to supply Chinese companies with funding, the regulatory environment hinders the free flow of capital. International investors are often channelled into offshore investment vehicles with convoluted structures that are difficult to understand and to value. For example, many equity investments do not have a direct claim on operating assets located in China.

Many of the capital shortages exist because the government continues to limit the supply of equity offerings. The current policy is to allow state-owned enterprises to list first; some companies list because they are instructed to do so by the government.

Until as recently as July 2000, China did not formally recognise the value of private entrepreneurs or private property. There is a long tradition of distrust of those involved in business. Only in 2001, when the Communist party realised that private enterprises were driving growth in the economy in spite of government policies and traditions, did it grudgingly allow private entrepreneurs into its ranks.

While the private entrepreneur can now appreciate his upgraded status (from evil to tolerable) he continues to be strained for capital and faces an uphill battle to offer shares, publicly or privately. Chinese bankers still find it more difficult to lend to a private enterprise with a good track record than to a less successful state-owned or state-controlled enterprise. Only recently have China's banks moved – cautiously – beyond the role of traditional policy supporters and cashiers of central command.

Some farsighted banks, such as the Industrial and Commercial Bank of China. are paying more attention to private entrepreneurs. Loans to private customers now account for 8 per cent of the bank's total portfolio, up from only 1 per cent three years ago. We are entering an era in which private enterprise will find favour in the financial system. But old habits die hard: new entrepreneurs will have an appetite far exceeding the ability of the local infrastructure to fund their needs. The door, then, is opening to alternative funding sources.

The China Securities and Regulatory Committee (CSRC) recently allowed the development of the first open-ended mutual funds in China. This move serves two purposes: it is an attempt to reduce market volatility and it strives to bring private savings into the markets. Over the next few years, this latent supply of capital will enter the market and help define the future of private equity financing opportunities. Greater attention to profit and loss will draw attention to China's best bets – private companies. This liquidity injection, combined with increasing international funding, will generate opportunities for managing and selling assets in China as the new capital demands better assets. Moreover, November's move to open the A-share markets to qualified financial institutional investors promises a further, albeit gradual, increase in supply.

The demand side of the equation is straightforward. Large and rapidly growing groups of entrepreneurs do not have access to capital. Bank debt financing is limited and commercial paper is difficult to issue. Stock offerings are tightly controlled and more political in nature than commercial. Internal cash flow and informal lending networks fund the explosive growth of most entrepreneurial companies.

This inefficient system has significant room for improvement. Over the next 10 years, China is likely to take steps to develop a more efficient capital market infrastructure that can support private enterprise. The elevated status at the Communist Party Congress of the 'productive forces of society' portends more opportunities for the entrepreneur. Venture capital firms that dare to be at the forefront of these changes will generate high returns when the market begins to clear more efficiently.

Driving factors

The unsatisfied demand for capital and the financial infrastructure that is rapidly evolving to meet this need reflect the country's economic emergence. Outlined below are some of the major issues that are driving the rapid evolution of this fertile market.

DEREGULATION China is laying the groundwork for deregulation. This will create opportunities for the consolidation of industries and investments in many sectors, including airlines, automobiles, chemicals, energy and financial services.

DIVERSIFICATION Traditionally, private equity investors selected investments in companies close to home. This rule is changing. In the US, for example, institutional investors have a larger appetite for alternative investments. Additionally, with US markets saturated and at a standstill, private equity managers are quickly expanding operations in Asia and Europe. China's risk/reward profile and low correlation with world markets make it an important addition to a global portfolio.

Consumer markets Many investments in China have targeted low-cost manufacturing for export markets, and the majority of international investment success stories have incorporated some export component into their business model. Now, however, certain regional consumer markets are becoming increasingly attractive – albeit difficult to access. Disposable incomes are rising rapidly and spending power is actually greater than that indicated by the raw data. China is
developing consumer market segments of 10m-50m people and regional economies of more than 100m people, which provide challenging but rewarding opportunities.

ENTREPRENEURS
Asia is home to some of the most highly skilled, low-cost technology professionals who earn just 10-20 per cent of the salaries of their US and European counterparts. Although their communications skills and productivity levels may not match global standards, these professionals are educated, skilled, diligent and eager to learn.

GOVERNMENT SUPPORT
Like other Asian countries, China has a long list of incentives for domestic and foreign companies promising technological advances. These investment incentives are tantamount to a subsidy for foreign investors, encouraging any initiative to increase domestic employment, promote technological development or generate exports.

REGULATORY ENVIRONMENT
The financial
finanthan that indicated by the raw data. China is developing consumer market segments of 10m-50m people and regional economies of more than 100m people, which provide challenging but rewarding opportunities.

ENTREPRENEURS Asia is home to some of the most highly skilled, low-cost technology professionals who earn just 10-20 per cent of the salaries of their US and European counterparts. Although their communications skills and productivity levels may not match global standards, these professionals are educated, skilled, diligent and eager to learn.

GOVERNMENT SUPPORT Like other Asian countries, China has a long list of incentives for domestic and foreign companies promising technological advances. These investment incentives are tantamount to a subsidy for foreign investors, encouraging any initiative to increase domestic employment, promote technological development or generate exports.

REGULATORY ENVIRONMENT The financial regulatory environment in China is underdeveloped, with capital markets being particularly immature. The Ministry of Foreign Trade and Economic Co-operation (Moftec) is finalising a law allowing foreignowned companies to establish stockholding companies that can list on A- and B-share markets. In addition to recent changes that allow Sino-foreign joint ventures to list shares publicly in China, stockholding companies may soon have easier access to yuandenominated A-shares and dollar-denominated B-shares. Listing will still be far from a smooth process, but the road is clearing for exits that draw on China-based liquidity.

More internationally recognised regulatory frameworks exist in manufacturing in general and in high technology in particular. Telecommunications, finance and transportation are among the areas most open to deregulation. China's entry into the WTO promises to accelerate the open-door policy of the last 20 years. Current laws and financial infrastructure are insufficient to support smooth private equity transactions, but as the new generation of political leaders takes control over the next few years, we will witness rapid changes in China's financial architecture and legal institutions.

DOMESTIC LISTINGS Domestic public offering is a restricted and coveted prize. Markets are riddled with problems of market manipulation, volatility and poor disclosure policies. While there has been much talk of opening a second board in Shenzhen for Nasdaq-type listings, it is hard to imagine that a more aggressive, less constricting market – as proposed for Shenzhen – could be more than a casino. Rather than waiting to see if the Shenzhen board will eventually open, many start-ups are choosing to list on Hong Kong's Growth Enterprise Market.

Shanghai's market capitalisation in November 2002 was US$560bn. Analysts, including David Hale of Zurich Financial Services and Andy Xie of Morgan Stanley, estimate that by 2010, China's total market capitalisation will exceed US$1,000bn- US$2,000bn. Many more are likely to be non-state-owned enterprises – up from 1 per cent today.

OVERSEAS LISTINGS Over the next few years, public offerings in Hong Kong and New York will provide the best international listing options. Worldwide appetite for China plays is enormous. In 2000, Chinese companies accounted for three of the top five equity transactions in Asia: China Unicom (US$5.7bn), China Mobile (US$5.2bn) and Sinopec (US$3.5bn). The China Telecom's offering at US$2.6bn is a more recent example of this trend. China Telecom's recent missteps do show however, that investors do not accept wholesale consumption of China plays.

While US markets offer a certain level of interest in China stocks, easier exits and more liquid secondary markets are found in Hong Kong, on the Hang Seng and GEM markets. It is also worth noting that in the Sinopec transaction, 20 per cent of the offering went to strategic investors, including Exxon Mobil, Royal Dutch Shell and BP Amoco.

Many investors have already recognised the opportunities. Early entrants in China's venture fund market include &,$, which has more than US$300m invested in China and has committed to invest another US$700m by 2005. The company says its funding operations in China deliver outstanding returns. Nasdaq-listed Sohu, for example, yielded a 325 per cent return on investment.

The turnaround market is also very active. The number of public and private firms in financial distress is on the rise, with high debt default ratios across Asia. Many companies may have a positive EBIT (earnings before interest and tax) rating, but they are still over-leveraged. Hence there are opportunities for turnaround partners to refinance, bring in new management, advise on cost cutting and expand new markets.

China's development model, which has always closely mirrored Asia's strongest economies, is changing. Before the demise of many conglomerates in Japan and South Korea, China supported the creation of multinational companies in selected industries. However, since this conglomerate model is becoming unfashionable, Chinese leaders will follow more recent Asian trends to privatise enterprise. China realises that it must allocate capital efficiently, in order to avoid the death spiral that has plagued the Japanese and Korean dinosaurs.

Many companies in China cannot raise capital in public markets or through bank debt financing. Both of these avenues are technically open but often difficult to traverse, and the financing needs are often too small for the public markets. However, smaller companies stand to gain the most as the economy is reformed, being better run and more mobile than state-owned firms. Consumer products and manufacturing companies are well positioned to exploit the advantages of China's export platform as well as the fantastic growth of middle-class consumers.

For example, the diversified US manufacturer Emerson is seizing opportunities in China. In October 2001, it paid US$750m, or 2.5 times sales, for Avansys Power Co, division of Shenzhen's Huawei Technologies. The deal demonstrates the value of wellrun Chinese companies and the potential for trade sales. Emerson decided that instead of taking the typical route of a joint venture or greenfield wholly foreign-owned enterprise, it could just buy access to the market.

Looking to the future, the changes already in motion will enhance opportunities for venture capital funds.

FINANCIAL REFORM WTO accession protocol promises to generate more, and deeper, reforms for China's financial system. Foreign banks, financial institutions, insurance companies and a host of financial intermediaries will gain increasing access to its markets. WTO protocol demands that geographic and quantitative restrictions on foreign companies be gradually relaxed and essentially eliminated by 2006. This means that foreign financial institutions will soon have access to Chinese companies and individual clients.

Many reforms are in full swing. These include the development of asset management companies, qualified financial institutional investor programmes, stronger credit policies at Chinese banks, increasing attention to and understanding of international accounting standards and a broad push for the implementation of corporate governance policies.

CAPITAL MARKET LIBERALLSATION Full capital market liberalisation will take many years to implement. It is important to recognise, however, that considerable achievements have already been made in developing securities and banking regulations. A new securities law came into effect in 1999 and there is consensus within China that capital market liberalisation is a crucial factor if the country wants to compete globally and, more important, fuel domestic demand.
SState-owned companies have voracious appetites for funds, partly due to the legacy of state planning and social welfare responsibilities. Many SOEs fund working capital with bank debt, running a perennial deficit. It has always been easy for them to go to the government and banks for funding, threatening that, without funds, their workers would take to the streets in discontent.

Over the years, the state has tried repeatedly to wean SOEs off their dependence on cheap capital. The development of asset management companies that hold non-performing loans was a recent step to make them more accountable. A natural next step was to open the public capital markets to SOEs. Legal person shares are now open to foreign investors. As public companies, they will have to answer to the public and will be more obliged to implement corporate governance policies and international accounting standards.

The SOEs are being allowed to list first, but waiting behind them are many private entrepreneurs. The growth of private enterprise in China is nothing short of remarkable, particularly in coastal provinces such as Zhejiang, Guangdong and Fujian. Every day in Shanghai an estimated 300 new private enterprises open for business. Over the next few years, more private or semi-private companies will enter the public equity markets. These firms will represent enticing investments and will raise the bar for all companies, state and otherwise, that operate in China.

GROWTH OF PRIVATE ENTERPRISE The surge of private enterprises will fundamentally alter the country's economic structure. Fifteen years ago, their contribution to GDP was close to zero, at least in formal calculations. Today, private enterprises contribute more than 20 per cent, and in excess of 60 per cent if semi-private co-operatives are included in the definition. Private and semi-private companies represent the best growth prospects for portfolio investment in China.

PRIVATISATION OF FINANCIAL INDUSTRIES The privatisation of banking and financial institutions is yet another demonstration of market forces at work. China's traditional banking structure was woefully inept at allocating capital. The scope and scale of nonperforming loans, as well as the massive capital shortages at Chinese companies, are a testament to the old structure's failure to meet market demands. Current demand for capital is strong, and though the domestic savings rate of 35 per cent should be sufficient for funding local companies, the mechanisms anisms for distribution are underdeveloped, precipitating an acute shortage of capital.

Until recently, direct equity investments in the form of FDI represented one of the few legal windows for participation in the China market. Indeed, the yuan remains closed for capital account transactions. In the short term, there are unlikely to be any major policy changes in capital account convertibility, although the introduction of qualified foreign institutional investors was a significant step in this direction.

China's equity markets are characterised by relatively low liquidity and high volatility. Most participants are small retail investors. Generally they are speculative and in search of short-term returns. As institutional investors such as insurance companies, mutual funds and pension funds become more active, the markets will gain liquidity and stability. China needs to mobilise longterm financial resources, and institutional investors – both foreign and domestic – will serve this purpose.

OWNERSHIP After many years of working together within somewhat forced joint ventures, where incentives and objectives were often not aligned, many Chinese and foreign companies no longer want the burden of a joint venture partner. Instead, international companies increasingly prefer to set up wholly foreign-owned companies. Chinese companies are also more willing to go it alone, but many lack the financial wherewithal and global reach. Venture capital firms can add value for many of these firms.

China is no place for passive investors. Investors need to understand the business and the local environment and to work with the assets on a regular basis. Investments of one to three years are primarily, if not exclusively, in unlisted companies. Shareholder rights, domestic demand, productivity, information deficiencies and exit strategies are all issues that will command the attention of investors over the next decade.

SHAREHOLDER RIGHTS The lack of minority shareholder rights is a problem throughout Asia. Unfortunately, a formal structure that will promote sound corporate governance and protect the rights of minority shareholders in China will be difficult and time-consuming to set up. China has few laws that protect minority interests, and most board directors are insiders. According to a circular issued by the CSRC in August 2001, one-third of all public board members must be independent by June 30, 2003. Nevertheless, because of the lack of legal infrastructure and international corporate governance standards, investors need to be more diligent in monitoring their assets.

GROWTH Long-term growth depends, among other things, on the creation of domestic demand and development of talented, competent management. While China still depends on exports for more than 35 per cent of its GDP, the economy is driven by domestic demand. Continued population growth, increasing educational levels and high investment levels should ensure high single-digit growth.

Unfortunately, the most important component of long-term growth – productivity – is still lacking. Demographic trends and increased capital investment point to continued growth but at some stage during the next 20 years, unless it solves the productivity conundrum, China's economy may suffer a severe shock similar to the one that has befallen the Asian tigers.

INFORMATION INFRASTRUCTURE China's credit agencies are woefully underdeveloped. It is difficult to perform background and credit checks on employees and suppliers. A wellattuned network of personal contacts is often the most effective way to determine creditworthiness.

EXIT STRATEGIES Current exit strategies for most private companies are limited to trade sales and listings on international exchanges. However, the domestic exchanges are quickly becoming a more viable exit. Funds that build to exit in five to seven years are likely to find many suitors.

Trade sales and public offerings are both technically legal in China. Trade sales are somewhat cumbersome because the transactions are new for this immature market. But as more market rationalisation occurs and WTO agreements are implemented, trade sales will become more common and certainly easier to transact.

The real question on most investors'minds is, "Who will find China's Apple, Genetech, TSMC and Microsoft?" China will develop huge success stories akin to Sony. The market presents many difficult challenges, as well as ambiguity and high risk. Venture capital funds are at an advantage when they operate in environments where there is a great deal of uncertainty and information gaps between investors and entrepreneurs. China has these characteristics in spades.

A version of this article first appeared in The Journal of Private Equity. Francis Bassolino is a Lecturer at the Graduate School of Business at the University of Chicago.