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Lunar Monthly Update

IPOs have been the dominant exit form in China since 2007, creating an “IPO-or-Bust” mentality among the Chinese private equity community that is characterized by an overwhelming focus on public markets. A corollary has been the “Pay-up-for-PIPES” trend.

From 2005-2010, PIPE or Mezzanine/Pre-IPO transactions have accounted for over half of private equity deals in China, with another 25% being growth capital transactions predicated, for the most part, on a near-term listing (see Table 1). These transactions have commanded a premium for either their listed status or the prospects of an IPO, with returns modeled on highly-valued comparables, rather than underlying value.

Exacerbating this has been ChiNext, an exchange for high-growth Chinese companies akin to NASDAQ. The enthusiasm for ChiNext is best summarized as the Hepalink effect (see Table 2). Note, comparisons can be found on NASDAQ, an increasingly Chinese stock exchange located in the United States, a country of Groupon users currently grappling with the Facebook effect .

We have been cautious about paying up for PIPES, or chasing pre-IPO opportunities. It is hard to overlook the success of others in this regard, but believe there is reason to be alarmed and stay focused on value opportunities within our core competencies. A few observations:

• The arbitrage is collapsing. As of 5 January 2010, ChiNext listed companies were trading at an average P/E ratio of 106x. This figure had dropped to 80x by January 2011 and was down to 53x by 14 April 2011. Several PE and VC investments in ChiNext listed companies are now underwater, despite listing at sky-high multiples. Investors in unlisted companies who believed this mispricing would persist will fare worse.

• Lack of control or involvement. PIPE and pre-IPO investments provide limited involvement or control, leaving little room to solve problems as they arise. General managers, board members, and chief financial officers at 37 ChiNext companies have quit since their companies listed, leaving financial investors subject to lock up in a precarious situation.

• Fraud. Evidence of poor due diligence by private equity firms, or outright fraud by newly-listed companies, should be alarming to passive pre-IPO players who have less insight into what they own. High profile cases are increasingly widespread. Arguably the most notorious are businesses listing through NASDAQ reverse mergers – from informal word of mouth in the market, we believe the vast majority of these businesses have materially overstated revenue or earnings. Front-door listings have not been immune: notable concerns have been raised in regards to China Forestry (HKSE: 0930) and China Media Express (NASDAQ: CCME).

However, increasing capital markets activity will have positive long-term impacts.

• China is seeing an emergence of cash-rich, large market cap private enterprises with increasingly talented management teams, whereas previously, only SOEs had the resources to undertake large acquisitions. Linktone, and its value-added archrival Tencent, are a good example. Ten years ago, Linktone had just raised US$7 million at a US$35 million valuation; Tencent was in the process of selling a controlling 47% stake to South African media business Naspers for US$32 million. Tencent’s market cap is now just shy of Facebook’s (US$50 billion) and is sitting on nearly US$2bn in cash; Linktone has fared far worse but peaked at US$750 million and still sits on about US$100 million in cash.

• Debt gone wild. 2010 saw record debt issuance for Asia-ex-Japan. Synthetic RMB debt issuance exploded, particularly for the Chinese real estate sector, and we expect to see a broader range of private sector Chinese issuers exploring this market. Further, Perpetuals were introduced to Asia, with tenors stretching out to 30 years. While some of these trends could strike one as disturbing, it will create credit curves, alternate financing channels and possibly a robust distressed market.

Our conclusions

• M&A activity should rise dramatically in China, driven by companies accumulating talent and liquidity. Companies fortunate to have benefited from the recent liquidity surge will be well positioned, or pushed, to make acquisitions to utilize capital.

• Investors in simple businesses that are reasonably priced and logical acquisition targets are well-positioned to benefit from expanded exit opportunities.

Lunar | March 15, 2011