Year-end review: Letter from Shanghai

Regular PEI Asia commentator Rob Abbanat, managing director at Silver Rock Group, reflects on a tumultuous year in Chinese private equity.

Just twelve months ago the state of affairs appeared pretty grim from where I was sitting. Amidst the worst recession in 60 years, the Western middle class contemplated the real possibility of soup lines not seen since the 1930s, and almost overnight stopped buying Chinese goods. This was bad news for the country known as Manufacture to the World. “Made in China” suddenly became “Made redundant in China” as hundreds of export-oriented business began closing their doors and unemployment began to skyrocket. And manufacturing wasn’t the only sector feeling the pinch.

Let’s not forget that this recession had its own moniker: the credit crunch. In parallel to the evaporation of credit worldwide, so too dried up the enormous amounts of foreign direct investment that had been feeding the Chinese industrial engine. The appetite of Western investors for Chinese companies seeking IPOs or reverse mergers on Western exchanges vanished faster than Bernie Madoff’s credibility, and China was suddenly facing a shortage of inbound capital to support the growth of private enterprise.

Compounding this was the fact that 2008 was an unmitigated disaster for the Chinese A-Share markets, which lost more than 70 percent of their value and took top seat among the world’s worst-performing markets. And with the implosion of the A-Share markets, much of the domestic wealth that flowed into private equity deals also evaporated. For those of us who make a living by making deals, it was the worst of times.

Amidst this backdrop, with pundits portending that the country may struggle to grow even 6 percent in the coming year — as if that were somehow shamefully low — China stepped intrepidly into 2009 and never looked back. While the rest of the world was limping into the New Year, China stood firm on its gargantuan foreign currency reserves and its well-capitalised banks, which had wisely kept their noses clean of subprime debt. Beijing quickly launched a highly effective and impressively large government stimulus program and the results were felt almost immediately. By the end of the first quarter, it appeared that China didn’t even know the rest of the world was in a recession.

Optimism returned quickly, shopping malls filled once again, and unbridled growth resumed. More importantly, the domestic A-share markets began climbing rapidly in 2009, and are now once again among the world’s best performing markets. In a momentous display of good leadership, the Chinese government took wise steps to shepherd the economy away from being export-led, and implemented numerous polices that have quite effectively increased domestic consumption. In parallel, they also implemented a spate of new stratagies that have helped to foster a surge in the Country’s domestic financial services industry, leading to an explosion of new RMB-denominated investment funds. For the first time ever, Chinese private equity funds have begun to overshadow foreign funds operating in China. All of this has fed the Chinese economic machine, and economists no longer question whether China’s GDP can grow 6 percent in 2009 — the actual number looks closer to 9 percent. Indeed, what a difference twelve months makes!

As 2009 draws to a close, those of us who make a living in financial services in China have much to be thankful for. Not the least of which is having jobs and deals: while many of my peers are still struggling to get back on their feet in places like New York and London, China is once again a red-hot market for investment activity. Perhaps it is too hot.

Looking ahead, I can only imagine what circumstances might colour my year-end review at the end of 2010. Of one thing I am certain: China’s stature as a global economic powerhouse will only be greater, and its GDP will probably be 9 to 10 percent bigger then than it is now. And while I remain a bullish believer in China’s future, I also am seeing some worrisome trends that will likely have a big impact in the world of Chinese private equity and investment banking.

To begin, China’s domestic financial services industry has long suffered from a lack of experienced investment professionals — until recently, most were foreigners. With the mushrooming of RMB funds, LPs are increasingly focusing on locals to serve as GPs, believing (rightfully so) that they are better able to interface with local entrepreneurs. But the availability of experienced local talent is still quite small. Inexperienced fund managers, caught up in the fervour of the day, are driving an unsustainable rise in valuations. Consider that the recently launched Growth Enterprise Market (GEM), which is intended to be a Nasdaq-like venue for small- and medium-sized Chinese enterprises, is currently boasting an average P/E ratio north of 50. This, of course, makes life difficult for foreign investors who offer what by comparison are paltry valuations when competing to invest in the same companies. While I fully expect that China’s domestic exchanges will improve substantially in depth, liquidity and regulatory oversight during the next several years, I hope that they will also become less volatile and less prone to exuberant spikes.

Another worrisome trend is the appearance of real-estate bubbles in some of the major metropolitan areas. Speaking from experience, the gap between rents and mortgages in Shanghai yawns so wide as to belie a huge bubble in residential property. As with the equities markets, I expect that real estate will only grow in the long term, but may suffer some difficult times when demand can’t keep up with prices in the short term.

Perhaps most worrisome is the prospect that China’s aggressive stimulus policies may take the shine off the reputation of Chinese banks. As all of China’s lending institutions are controlled by the government, they were told to lend enormous amounts of money — mostly to other state-owned entities — as part of the stimulus program. So much so that I have no doubt that we will see potentially dangerous rise in non-performing loans before the year is out. Coupled with the problems above, I expect some bumps along China’s 2010 growth path.

Nonetheless, none of these factors will dim my view that China offers more opportunity for growth investing than any other major economy. Even as I write this, Western fund managers facing anemic growth in their home markets are looking ever more closely at China as the new land of opportunity. This bodes well for investment professionals who know the ropes and can bridge the gap between East and West. So, with another twelve exciting months in the Middle Kingdom under my belt, I’m as eager as ever to jump into 2010. Let’s see how it unfolds.

This article first appeared in the PEI Asia Annual Review, which was published with the December/January edition.

Robert Abbanat is managing director at Silver Rock Group and lives in Shanghai. Silver Rock Group is a Dubai-based fund that provides growth capital to China’s most promising small- and mid-cap enterprises. Rob can be reached at