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LI YING SITS down at the table and smiles. Her black hair hangs in little bangs, reminiscent of the Mad Men character Peggy Olson. First impressions mark her down as a slightly prim housewife but the eyes give her away – they crinkle at the edges knowingly. She engages with questions she wants to answer and bats away the rest. She doesn’t smoke, and doesn’t touch her sparkling water. It’s a damp Shanghai evening and we are taking shelter at an excruciatingly funky bar in a boutique hotel on the South Bund. However, she rebuffs the waiter’s suggestion of a glass of wine or some nibbles. Her facade never drops – this, behind the prim hair and penny-round glasses, is a formidable woman.
Li is one of a new generation of Chinese investors. She juggles a personal life (a husband, a son and a social life) with a full-time job – she won’t say what exactly but it is something to do with banking. And when she’s not doing that she dashes around mainland China looking for new, high-growth investment opportunities in which to channel capital from her $140 million private equity fund.
Synergy Investment Management (don’t bother looking for it on the internet, you’ll find only glancing references) is now nearly four years old. Founded by a throaty and equally enigmatic Shanghainese man, Yan Weidong, one of five Synergy directors, in late 2007, it is as pure a form of private equity as one can ever find.
Yan and Li, along with “around 20 other” shareholders, Li says, created Synergy in order to plough their own not inconsiderable fortunes into high-yielding investments across the People’s Republic.
Yan himself has Rmb30 million ($4.7 million) of his own cash invested in the fund. Li has Rmb2 million parked in Synergy but she is quick to add two caveats: she is paid a handsome fee for managing the fund (again she declines to put an estimate on her “generous” annual stipend); and second, the investment only constitutes “1% to 2%” of her total wealth.
Synergy started out slowly, before gathering steam. It raised $10 million in the first full year and $30 million in 2009. But 2010 was a banner year, with $60 million in fresh collateral being swept into the fund by new and existing shareholders. This year it has continued in that vein, with $40 million raised in the first half alone.
Its investors are drawn from a disparate demographic scattered across the booming Yangtze River Delta (YRD). “Most of our investors have their own businesses, mostly in manufacturing,” says Li. “One has a big engineering company; one has a shoe factory. Another makes bullets for the military. They are all very wealthy people.”
The fund’s owners and shareholders have more in common than their personal net worth. None of them – ironic, considering where we sit – comes from Shanghai, a city with myriad other ways of raising and making money. And they all know and trust one another.
Yan emphasizes the point by stabbing his finger on the table: “We are all old and good friends, and we are all in some way old business partners. We know who everyone is within the club, and we know what they are good at. Everyone is good at something and they all contribute to the fund in some way.”
Thus Li was appointed managing director because she has a history of investing money both on the mainland and offshore in Hong Kong. Yan worked for 15 years at a rural fund management company, Zhong Nong Xin Agriculture. Other members of the club know specific industries inside and out. They know a good investment opportunity when they see it, tipping off Li and the other decision-making directors when they see the chance of making a quick buck.
Investments vary by the year, depending on shifts in government policy. Real estate was the flavour of 2009 and 2010, along with industrial firms and infrastructure projects – investments that benefited from government largesse following China’s $600 billion November 2008 fiscal stimulus package. This year in turn there has been a further shift away from the booming property sector towards natural resources and commodities.
And the investment structure – lean, intelligent, malleable, using old-fashioned instincts and the benefit of first-hand industry knowledge – clearly works. Neither Li nor Yan will provide a full list of previous investments (they both laugh at the suggestion) but they will part with a few details.
A $10 million investment, Yingde Gases, one of the PRC’s largest industrial gas suppliers, in late 2008, yielded a “splendid” return of 70%, Li says, when the company listed on the Hong Kong Stock Exchange exactly a year later, raising $408 million. Synergy sold its full stake in Yingde, which was also backed by Baring Private Equity Asia, during the stock sale, and returned the original investment including the $70 million profit (minus a 1% to 2% fee to cover legal and accountancy expenses) to shareholders.
Li reckons that shareholders will reap an annual rate of return of about 30% each year if they remain in the fund for a decade. That would be a handsome return way above the rate of inflation, on track to hit 6.2% in the third quarter of 2011, or the miserly returns offered by mainland bank deposits and savings accounts.
But she bridles at the assumption that Synergy pays its shareholders once a year, at the end of the financial calendar. “No, of course not,” she replies, looking surprised, even offended, at the suggestion. “After each project is over we always pay out. Why should we pay ourselves only once every 12 months? That makes no sense.”
Indeed, there are many ways in which Synergy and funds like it are wholly different from the classic, western-oriented concept of private equity.
Speed of investment is one: Chinese funds such as Synergy can pump money into capital-hungry assets and investments within days, even hours, rather than weeks or months, as is often the case with foreign buyout firms.
Another is the informal nature of the funds, operating often on a semi ad-hoc basis. Many in China describe them as investment clubs (ICs); others as Bi Xia Qian Zhuang (underground banks). The concept of these clubs or banks – the terms can be used interchangeably – started in Wenzhou, a coastal city south of Shanghai, infamous for its trading- and real estate-obsessed inhabitants. They have since spread across China but are found mostly in second-tier cities up and down the east coast.
It’s impossible to say how many of these clubs exist. Li believes there are roughly a 1,000 operating in the YRD alone. Maybe as many as 10,000 exist across China. “I wouldn’t even call them companies most of the time, or even funds,” says Robert Scott, a director of China BlueSky Ventures, a Shanghai-based consultancy providing pre-IPO guidance to investors across the mainland. “In most cases they are just loose groups of individuals who happen to know each other.”
And they know the local markets inside out, unlike foreign private equity firms, which have tended to find the People’s Republic a baffling and even humiliating place in which to invest. Foreign buyout firms have plenty of cash to invest in China but cautionary tales abound, notably Carlyle Group’s attempted $375 million takeover of construction equipment maker Xugong, abandoned in 2008 after three painful, fruitless years.
Foreign buyout groups, indeed, elicit only guffaws from Li and Yan. “They are just pigs that have eaten too long from the trough,” says the latter. “They stay at the Hyatt and don’t know where Fuzhou [a coastal city on the northern tip of the Taiwan Strait] is.
“How can Carlyle or TPG or KKR know what is going on in rural China, in the guts of China,” Yan adds. “They don’t get their hands dirty. We are on the farm mucking out the pigs while they are seeking to own the supermarket that sells the pork to customers. They don’t know or understand this country.”
In this Yan is probably only half correct. True, one cannot imagine Carlyle’s partners clearing up farmyard dung on the weekend. Even buyout firms acknowledge that they can struggle to get their message across here. “There is a sentiment here among some investors that private equity can’t be trusted,” says one Shanghai- and Hong Kong-based private equity partner and director at a middle-market buyout fund with $1.3 billion under management, who preferred to remain anonymous. (Underground banks, being illegal in the mainland, are a touchy subject here).
“Many really, really local Chinese entrepreneurs will trust a person they have dealt with for years, and who might speak the same dialect as they do, over the likes of a Bain Capital,” he adds. “So if these guys choose to deal with these kinds of [clubs], it’s hard for us to compete.”
To be fair, traditional private equity has made huge strides in recent years. Traditional buyout funds, Chinese-owned or under Sino-foreign management, are proliferating.
Moreover, investment clubs have proved successful in part because Chinese investors of a certain age (notably in their 40s and 50s) are wary of trusting with their capital people they haven’t known for decades. Many came of age in the 1980s and 1990s, turbulent decades when you still avoided the gaze of the state and had faith only in your oldest and closest friends. There is a sense that younger investors are more likely to choose classic buyout firms over the shadier-seeming underground banks.
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“We are still working within a legal system that is running to keep up with commercial banking, let alone hedge funds” |
“Most of these investors are aged 45 and above, at least in the bigger cities,” says David Wolf, president and CEO of Beijing consultancy Wolf Group Asia. “In the hinterland that age drops, maybe to as low as 30.”
There is also logic in the proliferation of these clubs. ICs have swollen in numbers, anecdotal evidence shows, particularly in the past year or two, as Chinese state banks have reined in commercial lending at the direction of the state. Local company owners, denied access to standard-issue bank loans, have turned to other pools of capital – and this is where the underground banks move in.
“These clubs are usually more widespread whenever there is a credit squeeze by the government,” says the Shanghai-based middle market buyout director. “A year ago, they suddenly became more popular because of the lack of credit availability – suddenly, traditional banks and funds have less money to pour into the economy.”
This in turn leads to all manner of curious stories, as entrepreneurs cast around desperately for fresh capital. The Shanghai director’s brother, who is also a director of an investment club, was recently approached by the owner of a textile factory in the developed eastern province of Zhejiang. The owner wanted to move the factory inland to lower-cost Anhui province, and needed cash straightaway.
Sydney Parmenter, founder of Beijing-based Strong Holdings, which advises foreign investors looking to sink capital in China and mainland firms keen to sell shares in Hong Kong and New York, is approached all the time by ICs on the lookout for fresh investment capital. “One approached me this month,” he said in August. “It was a coal mining company that was looking to ship coal to satisfy [orders from the country’s largest electricity transmission firm] State Grid Corporation. They were trying to raise money from friends, relatives, banks, private investors. Anyone, really. I turned them down.”
Where then do these ICs park their capital? Well, really anywhere that provides a heady return on investment. Synergy’s managing director, Li, says her club will continue to pump capital into rising mainland corporates seeking Hong Kong listings. “Hong Kong is the place with the best commercial policies. It’s best to be listed there and best to have your money there.” Synergy currently has stakes in eight mainland corporates hoping to complete a Hong Kong IPO.
But the club is always looking for new ways to invest. “Because of [changing government policy] we are always looking for new places to put our money,” Li adds. “Every year is different. For example, this year we are looking to take advantage of the currency policy.”
That also means avoiding two specific assets at present: real estate, as property prices flatten in most first-tier Chinese cities; and Shanghai- and Shenzhen-listed securities, whose values have been on a downward spiral for much of the year.
Most capital is currently being channelled by ICs into two key assets: unlisted companies operating in high-margin areas that are throwing off hatfuls of cash, and steadier firms with sustainable cashflows and solid business models.
Yingde Gases might be a prime example of the latter investment model. The demand for the former is evinced by the number of clubs pouring cash into metals (new and scrap) and mining. “In scrap metal,” notes our Shanghai private equity director, “you can earn thousands of renminbi per tonne of recycled scrap steel. And you pay no tax, so you get these sky-high margins. It’s a great place to make money if you know the right people” – and most underground banks do – “but these are companies that you would never expect to be listed.”
There are, naturally, downsides to these underground clubs. Defaults do happen; directors run off with their shareholders’ money. The likelihood of recouping capital when this happens is slim to non-existent.
And every few years, Beijing cracks down on these clubs, usually following spikes in hot money flowing across China’s borders. In June 2007, the authorities closed down a single underground bank in the southern city of Shenzhen, which was accused of remitting (see smuggling) Rmb4.3 billion in cash and assets, without a licence, into Hong Kong and Macau, over the previous 18 months. Some of the bank’s 55 clients, the State Administration of Foreign Exchange said at the time, were directors at leading Chinese state-owned enterprises.
Many other club directors and shareholders are also highly-paid government officials seeking ways to reinvest their wealth through underground channels. “These clubs are the way many leading wealthy mainland businessmen and leading government figures make their money,” says a well-placed source close to one investment club. “Some of these clubs have hundreds of millions of dollars to invest. I personally know a few members who are also senior managers of Fortune 500 companies in China, and sometimes government people. These are often people with serious money and serious power.”
In time, as China’s economy and financial markets develop in maturity and sophistication, underground banks will probably start to wane in number and power. Indeed, one of the reasons they exist in the first place is because mainlanders still have so few genuine investment options.
And there is no doubt that it has been a rough year or two for some underground banks. In Wenzhou, the city where it all started, a number of clubs invested heavily in fast-growing export businesses just as the financial crisis hit. Many went to the wall, a factor that might force officials to tackle the gaping holes in the system that implicitly encourage the existence of these clubs.
“Recent events in Wenzhou show China needs more formal methods of investment,” says WGA’s Wolf. ‘‘We are still working within a legal system that is running to keep up with commercial banking, let alone hedge funds. We need legal systems and a financial infrastructure, and an entirely new approach to civil law [to protect investors]. It will be a long time coming, but this is how things start.”
But the clubs are unlikely to disappear altogether. Notes one mainland private equity partner: “I can’t imagine a world where the underground banking system is entirely wiped out, as there are always entrepreneurs who can’t get access to cash because of the nature of their business.” This can be because of a company’s reliance on cash-based transactions, or its involvement in shady or even monstrous activities, from the smuggling of oil to the smuggling of women and children.
And there are signs that the government is looking to draw up rules that circumscribe, and therefore recognise, this dark but shadowy industry. Notes David Xu, managing director of Beijing-based buyout firm Mingly China Growth Fund: “The government has realized that there need to be more regulations governing these clubs, and there are discussions on that front [going on]. So the industry will become more and more regulated, and that is a good sign for everyone.”
