In this episode of China Money Podcast, guest Peter Fuhrman discusses why RMB funds will likely have a monopoly over the best investment opportunities in China, and why USD funds can nevertheless still make handsome returns for their investors.

Listen to the full-interview in the audio podcast or read an excerpt.

Q: Your firm has a focus on advising small and medium enterprises in China?

A: SME (Small and Medium Enterprise) in the Chinese context may be misleading, as we work with private companies with revenues of over $500 million.

But in China, for a growing dynamic private company, you could say 100% of them are capital constrained. They need money to grow, but the challenge is that only a tiny percent will (get PE investments). Of this universe of 70 million private businesses in China, only the smallest fraction will attract and close private equity investments.

Q: The situation usually is that a very good company may attract dozens of investors, but companies with poor qualities will attract no investors. The competition is intense (for those good quality companies), so what add-on value can an investor bring to help them nail down a deal?

A: Yes, it is a very competitive field. From the 70 million private businesses, PE will generally only consider companies with a minimum of 30 million RMB (around $5 million) of net income, to be audited. So there might be thousands of companies that qualify. Then each of these a thousand or so private equity firms may close five to ten deals a year.

So while it’s competitive in the amount of capital that’s available, a good private equity will still be able to find attractive companies and they may be the first investor who contacted them.

Q: Give us a specific example on a recent deal that you advised that illustrates a win-win situation for investor as well as for the company?

A: We recently advised a well-known consumer health care device company with $5 million profits. We spent a lot time defining who the ideal sources of private equity capital would be from. There are about less than ten firms with similar experiences with similar industry and similar company profiles.

At the end of the process, we got term sheets from five firms. The company was impressed with one of these PE firms, which is one of the most well-known global venture capital firms. They negotiated the terms, timing of the capital, so while this entrepreneur will be selling 15% of this shares for almost $10 million, we expect this firm will do a domestic IPO in the next five years.

Q: For the five firms that handed in term sheets, are they RMB funds or USD funds?

A: Ultimately, funding must come in as RMB. In this case, the investor will put in USD, and transfer them into RMB.

Q: So the company was comfortable with the added regulatory hurdles and prolonged processs to bring money in?

A: It’s not that prolonged. The investor has resources to help the company for the IPO process, even though they are nothing more than that, they’ve done it before. It’s already very valuable. Often, they have more than that. They may have established relationship with underwriters and the CSRC (China Security Regulatory Commission).

Q: To what extent do these resources include also having the right connections with the regulatory body?

A: It would probably be misleading and unfair to the Chinese regulatory process. It really isn’t done through connections and Guanxi.

What a good PE firm brings to the table is mainly credibility and experience. If the CSRC has a choice between a company with private equity investment (from a well-known firm) and one that doesn’t, it probably prefers to the one with PE investors.

Because the PE firms engage in forensic due diligence, it also requires the company to be 100% tax and regulatory compliant. What the PE firm brings is a comfort level that the company has gone through a very detailed due diligence process already.

Q: Lastly, China’s PE is facing increasingly difficult exit conditions. What does this mean for overseas investors wanting exposure to Chinese PE? Do you see these situations changing any time soon?

A: I don’t see it getting any better. That means for purely dollar-based investors who are trying to invest in private Chinese companies, it is becoming more and more difficult.

But for those with access to RMB, the story is difficult. What we are seeing now is also exits through M&A, and this is a new phenomenon, but will become more and more important. The good investment opportunities will largely be monopolized by local Chinese investors.

Our Guest Today:

Peter Fuhrman is Chairman and CEO of China First Capital, an advisory firm serving Chinese private firms raising private equity capital. Prior to founding China First Capital in 2008, he was a founder and CEO of Awareness Technologies, an enterprise software company based in Los Angeles. Peter spent 10 years working for Forbes magazine. He attended Cambridge University, Tufts University and Nanjing University.

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