We remain confident that China is attractive for private equity investors. Long-term growth prospects remain robust, driven by ongoing urbanization, rising consumption, and the emergence of inland China. Capital markets continue to develop, broadening exit opportunities for private equity investors. Financing channels for private enterprises remain scarce, making private equity an attractive source of liquidity for many entrepreneurs.
Since late 2010, we have seen increased concern over inflation, monetary tightening and the risks associated with moderating fixed asset investment. Over the past two months, fraud has exacerbated these concerns substantially. The acceleration in short interest of Chinese listed stocks demonstrates this, but also suggests that we have not yet nearly approached financial crisis levels, or the levels prompted by the July-August 2007 Shanghai A-Share selloff.
Fraud, in particular, has emerged as the possible “black swan” event that some have feared in the China market. There is no doubt that it is a cancer that has metastized from the obvious places (reverse listings) to more worrying and unlikely ones (Longtop and Sino-Forest). However, we believe that the fraud contagion, while of tremendous concern, can be contained, as we address later in this update.
We therefore believe that fear will give way to opportunity. Valuations in the public equity and debt markets have adjusted to levels where substantial value is emerging. Within the public markets in particular, we expect this trend to continue and have recently looked to take advantage of this through take-privates or by joining with management to acquire large equity stakes. None have yet fit our mandate, but the value is increasingly compelling.
The private equity and venture capital markets have been slower to react. Pricing has remained stubbornly aggressive, particularly versus public company benchmarks. However, we believe continued pressure in the public markets will eventually spread to the private markets, leading valuations of private transactions to moderate in late 2011 on into 2012.
Fraud has been a prevalent concern in China this year. Year to date, twenty-one Chinese companies have been delisted or have had their shares suspended from U.S. exchanges, summarized as follows:
Additionally, others remain ongoing subjects of investigation and/or speculation. The most notable are as follows:
In most cases we are not surprised, as the most pronounced scandals share common characteristics that should have been amongst the easiest-to-identify red flags — – reverse takeovers, inappropriate auditors, second- and third-tier advisors, dodgy directors, questionable underwriters and pre-listing investors who, in our opinion, undertook entirely substandard due diligence and missed in many cases blatantly obvious red flags that could have been easily uncovered through time on the ground.
To be fair, not every fraud is easy to detect, and some of the accusations are difficult to evaluate. Sino Forest presents an intriguing case in this regard. We cannot deny our concern about the increasing number of companies that were outliers in terms of prominent backers (China Forestry), strong underwriters (Longtop Financial) or direct comparables of our portfolio companies (Sino Forest), but note that these examples represent a small minority at this point.
We have also noted that the environment over the past few years has, to some extent, been welcoming of fraud. Ample liquidity, excessive confidence and increased risk appetites, coupled with limited on-the-ground resources, have given rise to the following:
• Competition to complete deals, particularly pre-IPO companies with limited track records
• Limited due diligence undertaken by weak, or arms-length, advisors
• Disregard for business fundamentals and common sense
• Lack of operational involvement or control
Given the recent dramatic price swings, short interest and panic, we believe there are certain good companies that are now valued at substantial discounts due to their association with China alone, or due to sharing a business model, auditor or investment bank with the companies most cited for fraud.
We believe it is our job to take measured risk, and we will never be entirely immune from long-standing concerns over fraud in China. However, we believe that our investment approach, pre- and pro-imposed funding, and our long standing processes mitigate risk. That notwithstanding, we believe it is prudent to review and refresh our processes in light of the valid concerns present in the marketplace.
Long Standing Processes. We take the following measures to provide checks and balances and ensure our process is thorough. Our investment team comprises three groups, each focused on their own investment thesis, industries and geographies. Our three teams, based in Shanghai and Chengdu, meet regularly to challenge and debate the ideas and pipeline opportunities put forth. Our transaction services team reports to our CFO and handle confirmatory financial due diligence, legal due diligence and portfolio company monitoring under separate oversight. We believe this provides a degree of independence when confirming initial due diligence, and also in the monitoring stages. Lastly, our consulting team oversees confirmatory business due diligence, again independently from the investment team, while working together with the investment and transaction services teams to build a value creation strategy for our portfolio companies. We believe our “three-headed” approach to investments at the pipeline and portfolio stages provides the necessary checks-and balances, second-and third opinions, and ability to ensure that key decisions are subject to vetting as thoroughly as reasonably possible.
Additional measures: We have recently worked to strengthen the independence of the investment, transaction services and consulting team to create further checks and balances. We have implemented a team dedicated to strategy, portfolio construction and risk management within the investment team to help guide our investment groups from the earliest stages of sourcing transactions. Additionally, we have selected the most appropriate public market comparables to our portfolio companies and undertaken substantial due diligence to addresses the gap between analyst reports and what we can learn being on-the-ground, as we still believe there are substantial disconnects between investment analyst research and operational realities.
Valuation and Exit Prospects
We believe the impact of the current environment on our portfolio companies is material, but contained for the time being. We have listed below a summary of the impact of recent market volatility on portfolio companies to demonstrate our thinking on valuation and actions we are taking to mitigate risk. More specifics on our valuation methodologies are included in quarterly reports (last distributed on 15 May 2011).
• Project Bottler (Juice Bottling). Bottler is currently marked at cost given limited comparables and operating history under Lunar auspices. Bottler also remains subject to final approval from Bank of China. Industry dynamics have been strong in the first half of 2011. Company internal controls have historically been poor and will be taken over by Lunar upon transaction closing through appointment of CFO and operating partner.
• Project Jaw (Fluorite Mining). Jaw is currently marked at cost despite strong gains in underlying commodity prices and consistently increasing company production numbers. This represents a calculation substantially lower than any reasonable market comparables. Lunar is actively involved in the business on the financial controls front.
• Project Pineapple (Asian Citrus). Pineapple is currently marked above cost, but at a reasonable liquidity discount to publicly traded Asian Citrus stock held. Lunar is currently evaluating the sale of publicly traded Asian Citrus holdings. Asian Citrus trades at an attractive valuation (Current PE: 6.7x, EV/EBITDA: 8.7x) and has tracked China comparables (see stock price versus the China Enterprise Index below), but has recently underperformed due to accusations in Forestry and Agriculture-related businesses (see debt levels for Chaoda and China Green, also below). Lunar is actively undertaking additional due diligence.
We hope that these monthly updates, taken together with our quarterly reports, provide insight into our activities and we remain happy to answer any questions.