Peter Fuhrman's  Instablog

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How much do you need to invest, how much profit will you make, and how long before you get your money back. These are the investment variables probed in China First Capital's latest research note. An abridged version is available by clicking here. Titled, "Expected Returns: Hold Period, Exit and Return Projections for Direct Secondary Opportunities in China Private Equity" the report models both the length of time a private equity investor would need to hold a secondary investment before exiting, and then charts the amount of money an investor might prospectively earn, across a range of p/e valuation levels, depending on whether liquidity is achieved through IPO, M&A or sale after several years to another investor.

This new report is, like the two preceding ones (click here and click here) the result of China First Capital's path-breaking research to measure the scale of the problem of unexited PE investments in China, and to illuminate strategic alternatives for GPs investing in China. China First Capital will publish additional research reports on this topic in coming months.

As this latest report explains, "these [hold period and investment return] models tend to support the thesis that "Quality Direct Secondaries" currently offer the best risk-adjusted opportunities in China's PE asset class." Direct secondary deals involve one PE firm selling its more successful investments, individually and usually at significant profit, to another PE firm. This is the most certain way, in the current challenging environment in China, for PE firms to return capital plus a profit to the LPs whose money they invest.

"Until recently," the China First Capital report points out, "private equity in China operated often with the mindset, strategy, portfolio allocation and investment horizon of a risk arbitrage hedge fund. Deals were conceived and executed to arbitrage consistently large valuation differentials between public and private markets, between private equity entry multiples and expected IPO exit valuations. The planned hold period rarely extended more than three years, and in many cases, no more than a year. Those assumptions on valuation differentials as well as hold period are no longer valid."

There are now at least 7,500 unexited PE deals in China. Many of these deals will likely fail to achieve exit before the PE fund reaches its expiry date, triggering what could become a period of losses and dislocation in China's still-young PE industry. PE and VC firms, wherever in the world they put money to work, only ever have four routes to exit. All four are now either blocked or difficult to execute for China private equity deals. The four are:

1. IPO
2. Trade sale / M&A
3. Secondary sale
4. Buyback / recapitalization

Our conclusion is the current exit crisis is likely to persist. "Across the medium term, all exit channels for China private equity deals will remain limited, particularly when measured against the large overhang of unexited deals."

Direct secondaries have not yet established themselves as a routine method of exit in China. But, in our view, they must become one. Secondaries are, in many cases, not only the best, but perhaps the only, option available for a PE firm with diminishing fund life. "Buyers of these direct secondaries will not avoid or outrun exit risk," the report advises. "It will remain a prominent factor in all China private equity investment. However, quality secondaries as a class offer significantly higher likelihood of exit within a PE fund's hold period. "

The probability and timing of exit are key risk factors in China private equity. However, for the many institutions wishing to invest in unquoted growth companies in China, a portfolio including a diversified group of China "Quality Secondaries" offers defensive qualities for both GPs and LPs, while maintaining the potential for outsized returns.

Returns from direct secondary investing are modeled in a series of charts across a hold period of up to eight years. In addition, the report also evaluates the returns from the other possible exit scenario for PE deals in China: a recap/buyback where the company buys its shares back from the PE fund. The recap/buyback is based on what we believe to be a more workable and enforceable mechanism than the typical buyback clauses used most often currently in China private equity.

Please note: the outputs from the investment return models, as well as specifics of the buyback formula and structure, are not available in the abridged version.

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Rather than discuss again the state of Chinese private equity and billions of dollars in capital flows, this blog will turn now to an even weightier topic. Pretty women. Specifically, the increasing abundance of them in China.

To my eye, Chinese women have undergone a spectacular makeover over the last 30 years every bit as dramatic as China's economic growth and modernization. I first came to China 32 years ago, as a graduate student. At the time, China was still partly under the leaden pall of the Cultural Revolution, which had officially ended five years earlier. College girls dressed like soldiers, wore no makeup and kept their hair short, often in stumpy pigtails. Army caps and threadbare canvas sneakers were considered fashion accessories.

Coming to China in 1981 after four years at university in the US, a fair amount of it spent chasing coeds, Chinese college girls seemed adorned mainly for calisthenics and bayonet practice. I duly kept them at a distance. Just as well, since had I fallen for a Chinese girl, it would likely have brought her nothing but ceaseless political browbeating and struggle sessions from her peers and professors. Chinese girls were not to be fraternized with. The thought barely even occurred to me. Instead, I feel under the spell of my very glamorous Italian female classmates, including one who became, for a brief time, a famous Chinese movie star and perhaps the most lusted-after woman in China. She finished her studies, left China when I did in 1982, an ended up marrying one of America's most famous movie actors. But that, as they say, is another story.

What a difference 30 years of hypertrophic economic growth can make. Deng Xiaoping is not short of praise or recognition. But, to his list of titanic accomplishments must be added that he did more to beautify Chinese women than any man who's ever lived. He liberalized not only the economy, but social attitudes and unwound the straightjacket that had bound women's fashion for decades. For, that he deserves the eternal gratitude of every man living now in China, myself included.

The magnitude of this change in women's appearance, over the last 30 years, cannot be overstated. If there is another aspect of China's modernization that created so many benefits, so much net happiness, with few if any offsetting disadvantages, I don't know of it.

Women in China today have opportunities to express themselves in ways that were unthinkable a generation ago. This runs not only from the clothes they wear and ways they style their hair, but also including the many elements of accessorized femininity, all of which were basically unavailable 30 years ago. There was no make-up, no proper skin creams, no sunblock, no perfumes, no nail polish, no hair dye, no properly-engineered underwear. Chinese girls looked a lot like toy soldiers because they were wearing clothes and underwear designed to neutralize rather than accentuate their curves.

This is absolutely no longer the case. To choose one example, on my short walk home from the subway, I pass through a 50-meter long underground mall with five different underwear shops, all selling domestic brands, and all very far down the "skimpy spectrum" towards the sexiest things for sale in a Victoria's Secret. The customers cross all age barriers. There is a popularity, as well as exuberance in China to the buying of sexy underwear that I never saw elsewhere, including Italy. It is also much more of an everywoman's activity in China.

From the little I can tell from glancing at the age of the customers in these underwear shops, Chinese mothers are almost certainly the world's largest market for sexy underwear. As for the fashions that are more visible to casual onlookers, Chinese women generally display a sense of style, of trying to look their best, across all ages and income levels. The most popular clothing comes from domestic brands no one outside China has heard of, not the famous Italian or French fashion houses. Chinese brands know how to design clothes to flatter the way Chinese are shaped.

I have one friend, who started and runs one of these larger domestic female clothing brands called Ozzo. He has over 400 stores across China and caters to middle class women over 30. He sees virtually unlimited capacity for growth for his brand across China.

While beauty is in the beholder's eye, it seems to me an objective reality that women in China are more attentive to how they look in public than at any time in recent, as well as probably ancient, history. This is true from the smallest farming village to the largest metropolis.

My sense is that colors here are brighter and more varied than you see commonly in US and Europe, where women tend to wear black. It's apparently meant to be "slimming". That isn't a major concern for the majority of Chinese women, from what I can tell. Food is plentiful, and appetites are large. I've personally yet to run across a Chinese women who engages in the self-mortification ritual known as dieting.

One small downside. Chinese women are smoking more than they used to. But, the number of women smokers is still a miniscule fraction of what it is in Europe and the US. One reason more Chinese women don't smoke is they know it damages the skin.

I travel within China more than just about anyone here, excepting airline pilots and government officials. Along with all the new buildings, roads and the new sense of national pride over the last three decades, this focus among Chinese women on looking and dressing well is the most emphatic statement of how far the country has come.

I can already hear the "feminist critique" of what I'm writing here, to wit, that to beautify is to tyrannize, and to "objectify" - a word I still can't quite define. But, the best proof of how much Chinese women themselves appreciate the changes, appreciate the freedom now to spend more of what they have to look their best, is how very few Chinese women have rejected all this and stay dressed as Mao once obliged them to.

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AVCJ Magazine's cover story, in current issue, on crisis in private equity in China caused by unexited deals, and the positive role direct secondaries might play.

Read complete article by clicking here.