Private Equity: East Asia - Chang Sun, Warburg Pincus Asia

well it's good to be back this is a new building that wasn't there when I was here graduated in 89 those days the most popular job when I graduated it was either consulting or or Investment Banking and private equity in those days was not that well-known today everybody knows by about private equity mainly because of some of the big deals they did like Burger King toys oz and you name it Freescale some some of the companies they bought touched our everyday lives and also because a lot of people very interesting and famous people who leave their previous jobs going to private equity Jack Welch even Colin power he is now adviser to a private venture capital firm in the Silicon Valley and you read about these guys every day you know in China same thing a lot of people get into the industry so I think I would like to talk instead of giving you cases formulas or techniques which in my days as a student I thought was very boring I would hide in the back row and take a little nap so instead of doing that I thought I'd just tell you the things I've learned as a private equity investor over 20 years since the days after I grabbed my graduation and I want to talk about the things that are very hard to manage and I'll give you a lot of examples maybe too much in one day but these are real life examples that I have lived through in my career and as they say you can never make enough mistakes in your lifetime so I hope some of the mistakes I've made as an investor would serve as lessons for you as well so first topic hardest things to get right I think these are the three the fourth thing is that our toughest obviously first question is whether you invest or not in a company when you've presented with the opportunity second is if you decide to invest in yet what kind of structure how much to pay for it how to negotiate to get what you want because it's never easy to negotiate a great transaction and once the deal is done you're set it's very difficult to change that the economics of a transaction it once it's negotiated and signed dealing with management is very important your diet is essentially cast in a business if you invest in the business I remember the very interesting saying capital seeks ideas it does not create ideas so we are managers of capital interested to us by investors but we cannot create ideas we have to find the people who have the ideas people like the inventors of search tools like Google myspace Facebook these are inventors and there may be dropouts from Harvard University or elsewhere but they create the idea they come to us for financing then we provide the tools of financial support and capital market access to make their dreams come true the last one I think is that is the hardest one is selling at the right time whether it's selling into an IPO selling into a multinational or pulling the life-support cord from a sick company once we know it's terminally ill this obviously is the hardest question why is it hard because there are many many variables and bulan asked me to talk about the difference between international private equity investing and investing in the US the top one says it political stability you don't have to worry about the current government the Obama government being toppled by some coup in the u.s. you don't have to worry about the US currency because you're in the country you don't have to worry about capital markets going upside down because of some turmoil like 99 in 1997 the financial crisis in Indonesia we invested in a bank called Bank Tierra which is a private bank the most profitable private bank in Indonesia financial crisis hit 200 banks in Indonesia overnight became 3 because the government decided to save these 3 national banks everybody else was just gone and in the in the Indonesia loop here when from something like 3000 to the US dollar to 9,000 10,000 14000 company was just gone disappeared couldn't find a trace of it I went back to a few years later to find the that family that owned the bank it was just painful to see them white hair you know stoop down very very sad because it's a macro event that we had to pay attention to if you had invested in Bear Stearns Lehman Brothers prior to the financial crisis tough luck it's a seismic event that changed the economy changed the industry so macro we think is bigger than micro micro meaning pick which companies to invest in macro means transformational events dislocations that will create or destroy businesses we have to pay attention to that otherwise your your history for example if you invested in a newspaper business a few years ago now you're toast why newspapers depend on advertising revenue for support that's how they live I was yesterday having dinner with a lawyer he told me he was handling the case of bankruptcy for the Philadelphia Daily News it's gone you know why advertising nobody looks for jobs from newspapers to pages pages anymore nobody nobody advertises for four apartments not nobody very few people you do online searches that business model is gone people get their news from internet right so it's very important to always bear in mind what industry trends what macro trends your Europe your you're dealing with and then emerging markets you have government intervention you have legal framework issues one example 2008 we Warburg Pincus had an investment in who and Jews which is the largest juice maker in China I was the director and we struck a deal to sell the company to coca-cola for 2.3 billion dollars if the deal went through it would have been the largest foreign acquisition of a Chinese company in China the Chinese government denied the deal denied to the our chance to sell the company our antitrust grounds that's government intervention in China you have to think about it we announced the deal both companies actually the deal involved three listed companies coca-cola listed in the US we induce listed in Hong Kong 20% share that unknown listed in France everybody approved the deal all the shareholders went through their shareholder vote board approval done deal only subject to government approval Chinese government said no deal after six months so shareholders lost money the stock went from $3 pre-announcement to $12 post announcement back down to four dollars a share so that's you have to what you have to worry about in countries like China India Brazil Mexico emerging markets business model that's another thing you have to think about why do I say business model when you look at investment your firm's own business model plays a role for example if you're a VC firm you don't want to invest all your fund where there's two hundred million dollar fund or eight hundred million dollar fund in one deal because the VC model is putting a lot of smaller investments million five million dollars into many many ideas hoping one of them maybe five of them will become a Google the next the next myspace Facebook so that's the business model of venture capital investment the other thing that's different is most of the buyouts are done in one shot you go to Toys R so you say okay buy you out tomorrow you pay ten billion dollars you're done VC investments phasing over time that's Iran be round sear on Iran you know why because these companies are new companies early-stage companies they need to achieve milestones they need to see progress and if you put too much money all at once in the very beginning the risk is too high the entrepreneur is like kid in a candy shop oh I have got all this money let me invest it all so the they spend it is splurged and then they come back to say sorry investor I'm out of money can you can you give me more then you ask them where are your achievements so that after 40 years Silicon Valley has developed a model where you finance the investor you spoon-feed them step by step as opposed to giving them money all at once buyouts no way you go tutorials us and said can I pay you 20% today and another 20% next year not possible because you're buying control so when you face with an investment you have to think about what you're good at in in the nine 1999 to 2000 framework VC's were having a ton of time successes they were selling companies they were getting you know outsized returns a lot of private equity guys even KKR wanted to get into VC this they failed they came back to the food to their their roots similarly private equity had a ton of success in in 1990s because leverage was available debt was cheap and many VC companies said oh let's raise big funds so instead of raising two hundred million dollar funds which are perfect for the VC model they raise big funds eight hundred million dollars a billion five last few years you know what they did return the money because they could not invest the money business model issue they could not find entrepreneurial companies where you could invest 20 50 60 a hundred million dollars all at once micro issue in the sector selection and investment thesis in in private equity it's not like throwing darts you have to have a thesis why this investment makes sense why you pick this company why at this time why add this valuation percentage of ownership in emerging markets it's like us in the at the turn of the century you went to JP Morgan john d rockefeller he said mr. Rockefeller can I buy you out for this amount he says I'm doing very well why do I need you to buy me out so it's true today in India or China well-run businesses they don't want to self control so it's impossible to use the US model in China India to buy our businesses that are growing fast managed well they only need a little bit of push in terms of growth capital as opposed to buying out so you have to think about your percentage of ownership in an entrepreneurial company if you become if you've been the investor become the largest investor with control you demoralize the original entrepreneur they lose the incentive to work hard because they feel like instead of feeling like an owner they become an employee it's no different than working in GE or at GM so we have to make sure they have enough at stake to incentivize them to continue to feel passionate about their businesses management quality very important we think management is key in every single investment we've actually looked back at the history of the firm in 40 years we've never had a deal fail because we paid too much most of the time instead a deal failed because management did not deliver they had this problem they had that problem they had hubris they got they got oh you know overexcited over some expansion bought a company more companies fail because bad acquisitions then they pick them then because of their own organic growth then you talk about deal specifics deal structure and so on and so forth there are so many variables that you have to consider that makes the question of investing are not investing the most important consideration and that's why most private equity firms have investment committees and they want you to to come up with a thesis they want to prove it they want you to debate and defend your thesis I think personally if you synthesize the success factors what we call key drivers for success you can look at three different things you know one is when you have a business model new business model like online gaming like search that never existed before and in these things go in waves if you capture the right wave at the right time you will be successful computerization like we first had the IBM then you had you know Microsoft and then you had Apple that whole wave building computers in Taiwan and all kinds of electronic gadgets you catch that wave first then you had the 1970s VCS accessible tech revolution you capture that you're you're in business the next one is telecom from ode fixed line telephone to wireless to a broadband to Internet to ATS ADSL to all kinds of things if you capture that you're you're in the telecom and optical equipment in that business you supply the tools and the equipment for the information superhighway you call in call that wave and then it's the internet obviously and then you have social networks online gaming and outdoor advertising the list goes on anyway these business new business models appear every day and it is the job of the investor to identify these new business models and try to find the investors that will take your money and bet on it then you have to anticipate the powerful trends for example in China when we started first in 1995 it's a big country going there so what should I invest in imagine yourself as an investor walking in with a billion dollars under management what do you do you buy power you by you by you you by railroads you by highways what do you buy it's a big big question because it's a blank sheet of paper very different from Investment Banking where you have targeted audience you have targets for example investment banking it's very easy to identify which companies want to go public you just go to them and market them your service to them consulting is also relatively easy you identify the biggest companies in the industry you say ok let me help you rationalize your business become number one probably equity harbor has no targets you go into a country or industry it's all your call so that's why it's hard because you stare you you take a piece of paper and you say ok map it out so when when I started in Warburg Pincus in 1995 I was the first Chinese higher than there was no Chinese employee we have no China operation I had to first come up with a name for what were Pinker's in China in Chinese in China then decide what to do so what idea was I worked with Mackenzie and The Economist's at different places come up with what we what I call 10 mega trends those are the trends that will shape the country and the society in the next 20 years I think that these 10 mega trends would influence a lot of things and have investment implications for example just take you through maybe two trends of the ten urbanization it's an overriding trend thirty to forty percent of the 1.3 billion people live in the cities the rest are in rural areas over the next 50 years the majority of them will move to cities the US for example the urban population is 96% so if you do the math 20 million people a year move into new cities and these cities are going to be gigantic today there are a hundred and twenty five cities in the you in China with 25 million people or more and you think about all these people move into cities what do they need housing building materials shopping entertainment restaurants then you think okay how do we take advantage of that you invest in in home builders invest in building materials cement and then you invest in consumer products companies as well as retail so that's a big one the next one is when people get richer they will want better health care they want to spend money not just down food but also on health care so drugs hospitals clinical services and so on so these megatrends will influence a whole generation of companies that would need capital to grow and they will grow faster than the others and that's how private equity makes money there are four ways to make money in private equity investing in growth assuming going and coming out at the same valuation the growth rate and the re is your return on capital that's how you are I our next one buy low sell high assuming you can arbitrage well you know this company is trading out you know ten times PE next year it's gonna trade at twenty times P you make the difference or you can be a turnaround specialist like Cerberus that part Chrysler and the hoping that they can profit from the turnaround of Chrysler obviously things went the other way too bad didn't work then the last one is leverage when things are not growing that fast they're kind of steady 2% 3% a year you borrow a lot of money which is taxes tax deductible that's how you make money one of the four ways but it growth on an in see these trends like in China consumerism or India investing into IT outsourcing you in you go into supercharged growth mode and then you can you can come out ahead of the market it's all about beating the market averages you know our investors are the largest pension funds in the world they want you to beat the SMP by 10 base a hundred hundred percent a thousand basis points that's the bogey that you have to get in order to do that you have to do one of the four things that I mentioned and you have to invest in some of these big trends like solar you know alternative energy ahead of the wave or you find a big location dislocation like you know the financial crisis in Asia or just last year when the u.s. went into a tailspin invest almost in anything you would have made money this is the part it's like playing golf you get a birdie you want to come back this is the best part of our business I love this part why because it's creative I was in investment banking from 1992 to 1995 goldman sachs one reason I left Investment Banking is it became not monotonous monotonous it was not interesting because it's a cookie cutter business you go to a company you write the prospectus you sell the stock you move on do the same thing again there's no creativity except in M&A M&A there's a poison pill there's bear-hug a lot of interesting things but not everybody can work in M&A private equity is M&A times two because in every single deal maybe three every single deal yeah at least by once you sell once that's both its M&A and you're in the driver's seat in the middle during your investment you could be buying companies you could be selling businesses you could be divesting things so that's why I think private equity is the best job in the world I'm biased obviously at least in the finance world but stretching and the negotiation is the most creative part of private equity because you are playing with human minds you're playing with people on the other side and valuation usually is a zero-sum game it's a if it a company is doing very well you go in and say okay I want to own 40 percent maybe 50 percent of your company and they will say how much do you want to pay now you can do all the analysis in there in the world that you want to do if the other side doesn't agree too bad No Deal and I'll give you an example the other one is obviously controlling negative control how do you get control if the other guy doesn't want to want you to get control but as an investor you have fiduciary responsibility to prevent bad things from happening if you only own 25 percent what do you do how do you make sure you have enough influence on the board that's what we call negative control stretching for downside protection not everything will go swimmingly well all the time what if some bad things happen and you have no protection your income and equity you die as the other guy dies but too bad the entrepreneur oftentimes will have no money in the game all they have lost is time let's say I have a business plan I come to you I say you give me six million dollars for 80% I put up my life for 20 percent five years later I achieved nothing you lost six million dollars I only lost five years of time maybe I can still find a job somewhere else so how do you protect against that we in techniques obviously professor Coquelin will tell you you can you can structure liquidation preference you sell the business you can you know you take you of six million dollars first rather than pro rata but that's the interesting part of our business one case in point aj info it's a software system integration company that approached me in 1996 it was high-growth but they wanted a lot of money in terms of valuation they wanted they wanted to value the company at ninety million dollars but they couldn't even produce model so I said how do you justify this they said oh all I know is we are profitable we have more Bank in the more money in the bank at the end of the month than we did at the beginning of the month that's how we know we are profitable and don't ask me why or how because we don't have a CFO so we send a young guy into the company to help them come up with a model the model showed that it would be a Herculean effort for them to get the net profit from 1 million dollars to 9 million dollars that they projected initially the project's 30 million dollars when we did them all do this no no no no we probably produce 10 minutes and then who became a nine million dollars so we proposed okay based on our work we said okay maybe thirty to fifty million dollars tops in terms of valuation they said no it's 90 million dollars we think it's worth a lot remember this is just before the internet boom and it was the company was very very hot a lot of companies were chasing investors were chasing a company there was a direct competitor they offered 90 million dollars no questions asked but investors are the entrepreneurs wanted us they wanted somebody who understood China and the internet and technology so we got into a room the three founders said nobody gets out of the room unless until we have a deal these guys are us educated they all just came back from the US and in fact one of them just came from back from San Francisco he would not off during the negotiation then he wake up and he would take over the you negotiating with me and the other guy so these three guys took turns negotiating mean to me trying to persuade me to accept their 90 million dollar valuation and in the end I cut a long story short I propose something I said okay you guys insist on 90 million I insist on 30 million what do we do let's do this if you can achieve nine million dollars of net income we go with your your evaluation for every two hundred million dollar shortfall we cut back valuation in lockstep this is like what we call a ratchet a ratchet is a step down evaluation that is key to your achievement in in that income that's how you ask them to put the money where their mouth is that mechanism now is very common in China you see almost at least half of the deals have that feature but when I first came up with the structure our partners in New York didn't like it they said if they fail to achieve the net income they projected you get a bad company times two if it does well you don't get the valuation you want but that's the reality unless you do that you the the ratchet you won't have the you won't have the deal so this is the result instead of in to prevent people from manipulating results for one year we stretch it to two years so it's average two year performance key to valuation not one year because you can move revenue or profit in for me one year to another and then we did investment for eighteen million dollars what happened company did very well but they'd failed to achieve their financial target by a mile so we adjusted took the company public in 2000 in fact is March 20th just before the the internet crash and they the company became very very profitable and in big market cap at the peak was four billion dollars when when they went public was only one billion but we did adjust our our cost from seven dollars a share down to a dollar ninety seven the story would continue with the selling part we induce terrific company great market position a ton of investors interested in the company and they needed to to get the money for pre-ipo restructuring company was so hot that we had over ten bidders three of which wired the money fifty million dollars I'm not joking into the company's account no due diligence no negotiation no documentation basically said keep the money there until the the lead investor shows up and we will go with their terms no questions asked so with that kind of competition what did we do we had to be people who wanted to only invest into the IPO with a discount hoping to profit from it was only like eight months before the projected IPO time so we offered the deal that that was a convertible preferred stock with a pic of cash at our choice with a coupon but that would survive the IPO which means if the IPO happens we still stay in that for five years we stay in the convertible position our decision to when we want to convert because once you convert you lose the protection and we also got a we got a guaranteed return from the shareholders so that the the majority shareholder would guarantee us 15% no matter what if the stock goes down too bad he still has to guarantee us because he was supremely confident that he would have success so it's a complicated structure we also got a little bit of a protection from the unknown what we called a disaster disaster put so if the company's operations went through the crack we could put out our shares to the two Danone and they had a call option on on our stock so we designed this in a very elaborate way to protect the downside the company by the way the company went public at the top of the market our cost was four dollars fifty cents a share the company went public at six Teek and the stock went up to $9 this year and then it dropped down to $3 this year because the financial performance was not there we announced the deal by selling to the company we did ran us a limited auction and I was the one negotiating with them with advisers Goldman Sachs and we had only two aus bidders red and blue you know who they are and blue blue dropped out red offered $12 a share compared to three dollars this year and then the deal god I as I told the story God got shot down by the Chinese government the stock went back down to four dollars this year we however had the protection from the majority shareholder so we got our 15% little brand this is an investment I made one of the earliest investments I made at the company at Warburg in 1997 it was a very good company crown jewel in a in retail Empire in Korea billed by a devout Christian who was very interesting had a fascination with Western culture he had six brands they were all English names in Korea the liberal brand is it little brands the shortened for a little brentano but it's in Korean and they had very good financials but the parent company borrowed too much money the problem got created when they borrowed ninety million dollars to build a golf course and that's the the problem with Asian entrepreneurs when they get successful they want to own their own golf course or mountain resort they need a financing and we saw the fundamentals of the business being very good but we wanted to protect against the downside so we invested in a preferred a participating convertible preferred stock participating means that even though we're convertible preferred when this common stock pays dividend we want to double dip so we get both 8% pick pick is a very very punishing instrument because you get paid in kind so what what happened was we invested at a certain valuation like in 30 million dollars in this case and every year we get more stock at or cash at our option we picked the stock option so you actually get the cheap stock every year at the same valuation back you know even a few years down the road you use that so that's why our initial ownership went from 46% to 56% because of the pic and it was an instrument that was it was very interesting a few years later they were very much concerned about control so this is a company that was founded by this entrepreneur Korean entrepreneur that didn't want to sell so on the eve of their agreement with us there the management team got together in the room talked until dawn they hugged and they cried collectively because they thought they would lose control so what we did was we went back to them we said okay let's separate economic interest from voting control we will not get voting rights beyond 49% which proved that to be a bad deal because later when we try to win go public that they would veto it we had a five-person board and they had three people including mat the CEO we have two people because of 49% so we for several times we voted to go public we wanted to go public we would have made seven or eight times our money if we went public but they were afraid that the 49% the 51% was too delicate and if we went public some guy would acquire more shares and they would lose control so they vetoed it each single every single time so in the end we wanted them we wanted to get out the only weapon we had was the 56% if we keep it going you know every year the clock was ticking and by my calculation if we went for another couple of years we would own 70% of the company so they had to find a solution get us out otherwise they would be toast so that's the that that's the dynamic unfortunately it is a zero-sum game you know you gain is the other guys the guy the other guys lost but as investors we have to stretch it for our own protection so the story did have a happy happy ending because the company was so cash generative they were able to borrow bank loans to buy us out we made less less money as we otherwise would have but at least we we had something like 40 percent I are gourmet largest electronics retailer in China about last year 7 billion dollars in sales extremely profitable this is the best buy of China we saw the stock trading at below-market 3 dollars this year Hong Kong dollars we felt there was something wrong because the company the market didn't understand them they were in public through a back door listing not front door listing and we went to them we felt that the company was not leveraged but a big company like this remember the four things four ways you can make money as a private equity investor leverage as another one this company was growing less than the market but we felt that the stock probably did not have the the potential to go five times but if you could leverage it even if the stock only doubled you would made three three and a half times your money because the leverage so what we did was we bought an instrument of 150 million dollars of convertible debt see be five years and we got some additional words to supercharge returns and we turned around we we borrowed money we borrowed 104 million dollars to limit our initial investment to only 37 million dollars which was mainly used to fund the interest rate differential what we did was we saw the fixed income portion to the banks which wanted to get you know instead of getting 3% from LIBOR they would have gotten seven or eight percent from our investment but we did we but the interest differential on the one half then we had to fund it upfront so that's that's why we put up the this was essentially the option value and this way if we lose money we can walk away it's 37 million dollars instead of one hundred one hundred and fifty million dollars if we make money the break point you can you can chart the breakthrough break-even point you can actually make you know supercharge return that's why this is a very clever structure that we're proud of that's very very interesting this is a technical point I want to go through it's the the advantages and disadvantage of having a CB against which you can finance we will make some photocopies of the material so you can you can see that later the third thing that is very difficult to get right is dealing with management for a lot of companies if if you have made an investment and the management is in place it's very expensive almost impossible to replace management because you lose time you spent a ton of time dealing with the issues that arise from changing management so you have to get it right and the important thing is to not deal with people who are bad partners if you deal with that people like you know those crooks at Enron or WorldCom you're the investor your investment goes down to zero I have some examples later on but the first one is integrity challenged high achievers on paper they look great but in reality when you deal with them their high achievement has nothing to do with you as an investor they may cheat you they may they may they may really double do you so you want you don't want to deal with them at all and there are some big company executives who are who grow up in in the environment of you know big staff expensive corner Suites and they cannot with the in a startup environment they fail they come into a company with fuse a few staff members and no support they don't know what to do we cannot deal with that and then there are control freaks who cannot build a team and we all know in today's environment you need a team to manage a very complex business if a guy is a control freak you cannot change the nature of that management manager and then there are shareholders who may have a different agenda than you do and alignment of interest that the common way of saying alignment is giving stock options but we all know stock options don't actually do the trick mainly because a lot of times stock options have no risk and it can be manipulated we know about the the back dating issue a few years ago when the stock goes down to this level and management got stuck awarded here they so that's back they did to this level so that we all make a lot of money and the forward earnings part I talked about in the example of Asia info if you're projecting five million dollars or ten million dollars earnings you end up producing one in 1 million dollars the investors are left holding the bag you pay too much for the business a couple of war stories the first point about about integrity a challenge to achieve high achievers as a company called pension foods actually I came up with the name because it was a company co-founded by me and my schoolmate from the school that pelant mentioned the page in foreign languages university we had a program that trained translators for the United Nations and this guy was in the class I had a a year ahead of me so he went to Geneva to become a simultaneous in interpreter for the United Nations from there he went to the Fletcher School and then Harvard Law School got a JD from Harvard Law joined clearly Gottlieb and Austria as an M&E lawyer then got headhunted by Pepsi to become a director for Asia and CEO for free delay North China they did two years of market study on the snack foods market and decided that potato chips was the thing the Chinese we had had very few things to munch on and in a billion consumers if you could sell one bag of potato chips to half of them you make a ton of money so he he was there for two years came to me with this with the business case and the study said look it's gonna be a humungous a growth opportunity why do I do this I quit with my team which I assembled over the last 18 months we've done all the study we know what to do and you give me the the startup capital let's start a business so we we stopped name called panchi and we warburg pincus put up six million dollars to own 80% i was the chairman he was the CEO and then we went into production seven or eight months later I came to the Warwick pingas calculus in New York City with a box of of potato chips I was very proud we had Chinese flavor seafood such fun hot and sour play-doh chips everybody was excited now we're now we're in big time right several months later I had an anonymous fax on my desk your CEO is moonlighting at a big company getting double salary should we as employees of pension foods all do the same I was really worried I said so-called mr. so-and-so the CEO said what is happening are you moonlighting at a different place he said no I said okay let me look into it next day another fax that name the company he was at and the position I got on the phone with that company and I said do you have so-and-so working your company they said yeah he's a senior vice president of marketing I said how long have you have you had him six months turns out he was using two phones one phone for pinching foods one phone for this European white goods company and he was selling him back and forth so I confronted him and I said look you know let's not make a big scene why don't you quit in a month and come back and you know we'll let bygones be bygones a month later nothing another month went by he said I we sat down he said really I cannot quit because you know I've made obligations to the I have obligations to this company so in the end I had to convene a board meeting and announced that today's agenda is for mr. so-and-so to resign and whether you like it or not you sign on this piece of paper later I found out the guy had outsides ambitions he really wanted to own his own helicopter his own private jet and this he thought it was too small the European company was a way to go second was he was actually secret he had a wife and two kids in Hong Kong he was secretly cohabiting with a miss miss Chengdu which is a big city in Fujian province they were living together and yet to finance their lifestyle with a second income high achiever but integrity challenged right needless to say I fired him we try to find a replacement didn't work got somebody else from his management team the business failed he cannot survive the startup business cannot survive the shake-up of a top management team we lost six million dollars the guy went on to three other businesses each of them I ran into the owner reported integrity problems gourmet electronics the owner mr. Wonka Nui was voted not voted ranked by Forbes for three years in a row as the richest guy in China build a great business but now he's sitting in jail overly ambitious had a secret life and had a take-no-prisoners approach let's see the performance great company look at the performance revenue triple this is when we invested in the company two billion dollars to six billion dollars in 2009 when we exited kegger 29% on revenue and 21% and then income market cap look at this 1 billion dollars to 5 billion dollars what went wrong we made the investment here stock went up 40% on the data of announcement he sold 150 million dollars he acquired the third largest electronics maker consolidated his position stop when way up he saw another 300 million dollars part of the the fourth largest company in the same business and then he did a placement for we didn't say how much he did another placement for three hundred million dollars what he did was he was the chairman and the largest shareholder by the Hong Kong stock exchange rules you cannot sell shares without announcing to the public he wanted to conceal that so he announced a gift of billion shares to his sister a week later his sister soldiers and at the same time the company was doing a buyback so I was a director I wasn't aware of it and the SEC SFC in Hong Kong launched a inquiry into this and and try to trace the the company documents we had a resolution a board resolution my name was on it I wasn't even even informed that we were doing the buyback so what happened to the money he probably got by my account about a billion dollars put up a billion dollars out of the company and currently he's been charged for money laundering because he exchanged the money through illegal means to gamble in Macau reported he lost 800 million dollars gambling and that's the use of proceeds alignment of interest it's very difficult to get management to think like shareholders and we need to get everybody in the same boat and it's it's really difficult and unless you have control you cannot change management and I have a few cases to go through but mindful of the time should we leave more time for questions ok ok alright one case this is a company that we invested in 1995 again was the I was the chairman I just bought my own kind I fired 20 CEOs in my career in 20 years and each one has a very interesting story this is one of them oh by the way this is a company that I fired a CEO twice it was a textile company the blocks were New York trader and me coxswain by the way was a street on their on their block in their home somewhere in the New York metropolitan area they were trading in China for a long time they thought in the u.s. you had all these mail order companies like you know we are all familiar with Victoria's Secrets you know Eddie Bauer these are mail order companies in China nothing so this error great idea let's do that they came to me to Ober Pincus in 96 they said why didn't you fund us and we have a great manager called one asylum when Ursula was the executive vice president of akela chicken dance which was at the time the second-largest mail-order company in the whole world the largest is also a German company and Werner decided to move to China to start this business very admirable but he gave us a business plan that would require seven million dollars to build a hundred million dollar business three years later we invested we ended up investing 27 million dollars and the sales was only 10 million what went wrong he was German Japanese ruined in six or seven different languages when I asked him what the Chinese consumers wanted he said they wanted what I can give them he was very arrogant so we had to fire him because after many seasons every time he had it he had an excuse it was either the flood flooding of a city or bad weather or you know some strike and at a board meeting I got really upset with him I said have you you have all these excuses have you ever thought that the reason might be you so he was gone this guy Taiwanese guy you know he's actually a dear friends so I maybe I should have just taken other names but he didn't he didn't work because he came from Taiwan also from a bit this is these both these guys are big company guys and he came from China Arab right a big conglomerate in China he couldn't manage the business when I let him go we only had less than a million dollars on the bank and about by his own account about 21 days from bankruptcy so at the time it was actually interesting he ended up in a good job Walmart was looking for a China head of purchasing and and I was arranged to have a phone call with Lee Scott the president of time so I recommended him he ended up becoming the fourth or fifth highest ranking executive at Walmart irresponsible for billions and billions of dollars of of purchasing and then we replacement with with a local guy by the name of Alfred gu who came from Bert Osmond a direct marketing company and the Shanghainese so this is another lesson learned you need a local guy to deal in a local business so story went down to in the end we sold the company for 25 times PE and a hundred million dollars cash but we only got it right the third time was that long 10 year investment 12 years actually I yet I actually got tired of serving as its chairman the promise store we invested this is one of the largest diploma stores in China after the IPO they lost focus it was on a tear doing very well but they started investing in real estate in unrelated businesses and the CEO was you know doing things that we thought were borderline so we had to replace him pull him back even though we only owned at the time of the investment we own 35% then not today we own 22% and after we refocus the company changed management stock went back to a historic high about two weeks ago we did a block trade through mobile Stanley was so down about a hundred million dollars worth of stock so far we have recouped a hundred hundred eighty five million dollars on eighty seven million dollars investment remaining is stake is worth three hundred fifty million dollars and here you can see the financial performance and the stock price went up to this and because a loss of focus went back down change management it's a happy story not always easy because you have to persuade him to do this this is the largest pharmaceutical company in China when we invested in the company the thesis was very simple market was growing at 15% a year and most of the companies in the sector were state-owned so we thought all we could all we needed to do was just to grow with the market and maybe cost-cutting taking the low-hanging fruit after making the investment we discovered that the company's profit as reported were was a result of negotiation you go to management we sit down with them you say you say okay we want you to produce 15% rate of return of profit growth for the next year they said okay fine you get it next year same thing it turns out that the company was actually a lot more profitable than we thought but they were all hiding the money in what they call little gold fault they were they were just hiding the money so that they could benefit because of the agency problem management had no stake in a company won its Regis example was one of the subsidiaries one year after we went in we discovered they system-wide 3,000 employees year-end bonus plasma TV the size of half of the sport every single employee got a bonus like that next year including the drivers they had something like a hundred drivers a fur coat as a year-end bonus so shareholder money was wasted like that and there was one year they were competing with a company in Sinjin for advertising money they were going to spend like 20 million dollars in in TV advertising and they told it was auction they told the other company unless you give us six Mercedes Benzes we will bid you and we will make you pay a lot more so that's the kind of mentality in a state-owned company and in the end what we did was look at the financial performance we had to change this heads of all six subsidiaries to make this happen double the revenue this is the US dollars right and quadruple the net income this will not happen if you have entrenched management and the interest is not aligned because of agency problem the last one is very difficult is doing the right thing selling at the right time example is a shame for the story I told cut we are cost was $9 97 when it went public twenty four dollars a share first they are trading open and ninety five went up to 120 biggest mistake I made was I didn't sell after the lockup expired it was still trillion $70 a share our stake 11 million dollars a cost at the peak was 900 million dollars worth 900 million dollars and then went down to 400 million dollars I got emotionally attached to the management team wanted to keep building the business the problem was it was building the the Internet backbone when that building was done no more business so they had to change their business model reinvent themselves which was a very hard thing to do and we ended up selling here for five times our money as opposed to twenty times our money so I learned my lesson next investment we reinvested in the company here at $10.80 this year in a few months it went to $30 a share I said Wow I learned my lesson a gene for that self stock went onto to reach a peak of $200 this year we made 300 million dollars from 80 65 million dollar investment as 700% I are we could have made a billion but three years later went back down to our cost and then it's going up so capital markets it's very very hard extremely hard to make the rational decision at this point we thought it was already overvalued when on so it's like the internet bubble you never know when the bubble would burst next investment Greentown a real estate company this time i said ok rnf same business same industry same market both listed in Hong Kong so we said ok it went from $10 a share to $19 a share we said let's hold on because rnf went up to $200 a share never saw that went down to $2 this year so in one case saying too late wrong key is selling too early this one we're having a soul Huyen juice we decided to sell after the IPO where we this is after the IPO 19 2007 when the indicators all reached negative the territories and we had a problem at that time if you remember at the Olympics the French president Sarkozy decided announced that he was going to boycott the Olympics the Beijing Olympics because of what was happening in Tibet and there was nationalism against France we unfortunately who and Jews had done known as a 20% shareholder so the the the owner wanted to get rid of done all that but the known didn't want to sell and we got caught in the middle I saw those numbers I said the company should be sold so Danone said we cannot sell and it showed the the majority shareholder who owns 50% says what if what if what if you buy me out if you don't want to sell don't know I said no no we can buy so we're stuck the only solution was to sell a third party so we signed a secret agreement to sell the company to rather either red or blue and we didn't we ended up selling to nobody the company's still there by the way we induce performance is slightly better but not much look at the stock chart invested here try to persuade them to sell announcement and then the deal got killed we got out this and because of the earth structure we were guaranteed 15% IR we got out okay but not great would have been better if blue red or blue could have bought the company now very quickly about private equity as a career I think it's the best job in the world because in the morning you go into the office you actually have a blank refute the sheet of paper you hang up your coat you can decide what you want to do it you can invest in the steel industry you can invest in the auto industry you can do it into the potato chips industry and it's a great business model piece because you make money it's 2082 he split as you know what we called carried interest if the investors make money you get 20% of the cut where else can you find a business where you don't have to put up any money or one even 1% of the fund and you get 20% of profit and instead of like a lawyer or a banker where you get called and you're on call 24 hours a day you don't have a client you are the client as a private every coding investor you at the top of the food chain you find transactions you find bankers to stretch it for you to sell it for you her lawyers to write documentation you have accountants to do accounts for you so I think it's a great business where results count and there's never a doubt they add you know just the stories I told you I can tell you you know for the next hundred days so many different stories very very interesting because everything every day there's something happening and best of all it's a life learning lifelong learning process process because everything I've learned in my life IQ EQ you name it you need to use it because you're dealing with people's psychology dealing with real-life situations you're dealing with capital markets and you Lambert learn enough if you ask me what you need to do to prepare yourself for a career go through this list and it's simply I don't want to elaborate on it judgment obviously is the key judgment of people judging or timing judgment of businesses and micro and macro issues it's a small industry not easy to get into 1995 when I started 47 firms in today's 600 firms but look at the number of employees only from professionals this is the u.s. from four thousand eight hundred twenty-six thousand this is the entire United States so it's a very small industry I have the stats here not 2,000 the hiring of MBAs this is the top 20 private equity firms total number of hires worldwide 40 u.s. MBA hires 30 and we hired six people with the second largest higher employer the largest is Bain at 8 worldwide in the u.s. Bain Capital hired five this year we hired 3 so it's a it's a difficult industry to get into because it's small but the amount of capital under management is humongous worldwide it's over a trillion dollars think about it the US economy is only GDP is only 14 children the huge amount of buying power concentrated in a few people and just this is total number of employees the number of partners is much smaller they make decisions remember that and a little bit about the firm we were we Warburg Pincus is one of the oldest private equity firms and one of the largest founded in 1966 and the block global firm we started in Europe in 1986 and in China and India in 1994-95 and we have about 42 billion dollars of investment a total capital invested 20 minutes for Q&A thank you I was curious as to whether Warburg has plans to raise and RB funding what you see is the advantages and disadvantages we certainly do because it's not because it's fashionable it's because it's inevitable inevitable trend if you think about it would you invest you know you British Pound Sterling in the in the United States probably not the natural thing is investing dollars in the United States so the natural thing in China to do is to invest RMB in in in China and also because the social welfare funds and other pension funds in China's swelling up they are finding they're trying to find an olive we are investors whether money comes from China or the United States it doesn't matter we need to find good opportunities for capital appreciation so we have to do that and it's it's question of when Harvie pharmaceutical is a privatization we believe that early privatizations are very very interesting they could be very profitable we did a privatization deal in the Czech Republic in a company called Zant Eva it was a pharmaceutical company that the state was running it wasn't profitable we bought a hundred percent change management give them the right incentive and made up almost 700 million dollars out of the transaction so it can be very profitable but it can be very political because there are so many government agencies involved it takes a long time it's a lengthy process and you need to have the right mindset but I I would say privatizations are very interesting and if you have the right angle the the they can provide very good returns see you mentioned the Chinese government's involvement in the juice company transaction and I asked a version of this question last week when we we're talking to a middle-eastern investor but how do you price in that political risk going forward in your deals where you're either act that you're contemplating an exit or you somehow have to take a stance on how important that kind of an issue could be I don't think you can price it against it you can structure against it so for example if you have a put option or you have a ir guarantee then you can get out but pricing this into other deals it's very difficult because entrepreneurs don't want to be unnecessarily penalized for one decision in an isolated case it's like taking a credit risk it's very difficult because if you want to be reinforced of all you want assets against the put option it's very difficult and we've never tested in court I would actually think about it when I talk about it internally I describe it as a nuclear deterrent as opposed to actual enforcement so you have this in your hand you're using this to force things to happen so it's you never drop the nuclear bomb but if you have the nuclear deterrent you can force the other party to come to terms and it's a way for you to force a sale to happen in the case of we and Jews because we can threaten that we want to exercise the put he doesn't have the money what do we do you can sell the company otherwise as a 10% shareholder we have no way of affecting a sale what kind of mega trends do you see are common in the US and China in the next 10 years in the US I think there's a paradigm shift in the energy world everybody has to rethink how they use energy how they pay for energy so a ton of VC money has been invested into solar into biofuels into thermal power so that's a game-changing event that will happen but the issue is really how you play it we've seen a lot of people losing money investing into internet style bubbles that would yield no no return the other one is the financial services industry in the u.s. there will be again a paradigm shift with the investment banks becoming bank holding companies private equity firms means you know sort of spun off because of the new regulations the Volcker rules and so and so forth whenever you have seismic changes like that you have opportunities for private equity well we hate most is status quo if there's no change there's no opportunity for us same is true of China you think about China and the other megatrends I I didn't mention our like ageing of the of the society China will will have a lot more people over 60 retired people before they reach you know sort of middle-income in in that sense they don't have enough money to pay for the retirees so think about the implications for the aging of the society environmental degradation is another degradation is another megatrend the environment in China you all know pollution is horrible and source of water and land air what we do with that you want to maintain the kind of industrial growth you've been having for the last ten years at the same time not polluting the whole Road with your industrial industrialization so new technologies that help manage the pollution problem will be quite interesting waste management connected with that so megatrends you think about things that would affect our lives affect the economy affect the entire society for the next 10 20 years we will create investment opportunities so our business invested equity businesses are thinking business it's it's consulting plus investment banking plus management that's why it's so exciting I think when you see relationships people automatically think corruption I personally think that relationships are becoming less and less important in in a country that is becoming more and more open remember corruption only happens when you have secrets when you have concentrated power when you have no transparency so Warburg we're a US firm just like Kiki are and Bain we're subject to what we call FCPA the Foreign Corrupt Practices Act you cannot do anything to to influence government officials through advantages like money or anything else so we do not believe that relationships are key to our success on the other hand the companies we investing must know how to navigate government relationships must know how to deal with governments because after all China is still a a non market economy yet it's still a centrally planned economy so it's a delicate balance but I think the key success factor remember I had a slide up there no relationship it's other things you know identifying the mega trends dealing with management aligning the interest and and selling at the right time not relationship that's not top of my list we run into companies all the time who claim that they don't need equity I don't think so unless you're Microsoft you're generating 35% net margin and Apollo cash you if you're growing at above market rate at some point you need you need financing but it may not be us because private equity is the most expensive form of financing the cheapest obviously is bank loans then you go up to sort of mezzanine that you're going to hybrid and then you go into other things like going public and private equity is the most expensive firm form so there will be a segment of the market that would not want our money so the best thing you can do in a situation like that is to make friends with them keep staying close to them hoping that they will need you for reasons other than money for example we have invested in two companies that did not need money at all hard being pharmaceutical the the the company I just mentioned never never use the money we gave them a total of 250 million dollars they actually paid dividends they their cash today is 500 million dollars I'm on the balance sheet never use the money why did they need us they needed us to be a change catalyst for change the media that is to be a change agent to change the culture of the company to change it incentive structure and therefore the company financial performance can go up the other company the the other example is a company called lepue which is a medical devices company that makes stents for you know if you have a hard problem the traditional way of doing this is to have a bypass new technology invented in the US and perfected around the world is to have a standard that would try to unclog that the arteries so this company makes that we invested in 2006 when the company actually didn't eat money at all what they needed was they had a state-owned shareholder and the entrepreneur is having problems with the shareholder like giving stock options and so the state-owned shoulder didn't want to give stock options so they wanted to broaden the shareholder base we stay close with the company and persuaded the shareholders to take our money we invested 20 million dollars for 20% they never used the money they actually paid us 9 million dollars a dividend so our cost went down and then we gave them another 7 million dollars for acquisitions the company went public October last year in 2009 our 20 million dollars today a cost around 17 is varied today at 500 million dollars but they never use the money so the best companies that actually a companies like that they come to you for reason other than raising capital like improving governance in creating the right incentive structure if the company that's desperately in need of money you have to think twice no these short answers we do not try to risk a just returns around the world you know why you can never justify an investment if you do that how do you price political risk in China or currency risk in China what we do is we again use a top-down macro approach we look at where the growth is from because private equity essentially is a growth business unless you're in buyout that's different in use leverage so if the growth in China's 11 percent to 10 percent and the US is 2 percent the answer is quite obvious but you may not be able to allocate all your money in in China because you know like a question here a lot of the entrepreneurs don't want your money so you have to balance the need for capital against the desire for capital and as a firm we have what we call executive management group which is a management committee I sit on that committee and we said we we are we're about a dozen people who run either egg geography or industry and we sit around and we talk about investments and we have a rough allocation in mind but it's never set in stone and the it sort of first come first so everybody surfaces their best deals to the to the committee and then we decide which deals have the best return profile adjusted against risk so it's never never a fixed formula it's more like a fear this business is a feel business you think well thank you being part of a global firm gives a distinct advantage doing business in China or do you think that it's not really an advantage as I guess the local it's both actually it's a double-edged sword on the one hand we have the global franchise like if we do a alternative energy deal in China we have the research team in the US that give us the technology the data for example we just made an 80 million dollar investment in a company that that collects gas draws for that sort of gas in coal mine and it's a very technical business unless we have the global expertise in New York we wouldn't we wouldn't have done the deal on the other hand the local firms make much quicker decisions they don't have to go through the global chain they can they can promise to the entrepreneur on the ground tomorrow fund you so it's a it's a double-edged sword but I think if you look at this in totality as a global firm I think we do have an advantage because of the 40 years of experience because of the resources that we can bring to bear on a particular deal here it was a hand up there ask you another one how do you manage how do you manage the IP risk intellectual we have to do due diligence there's no other way we are I saw a ton of proposals on biotech I then we discovered that more or less they were all trying to reverse engineer the u.s. ideas you can't even touch that so the the only way to do that is to do diligence over and over again to make sure you're as a megatrend I think Chinese companies export into the u.s. is a great proposition for the US can push consumer a terrible losing money losing proposition for the investors you know why because the RMB is rising so your costs are denominated in the RMB and your revenues are denominated in in in the US dollar and then you have Walmart and Kmart and Sears as your customers who are concentrated and extremely powerful they're pushing you to cut down costs so they can offer offer every day low price so it's a terrible combination for export oriented businesses that's why we focus on domestic consumption businesses as opposed to export businesses because it's it's a you know macro wise is not a great thesis hopefully how are the local shareholders welcoming to international firm international perspective does that help you as a changing agent or is it kind of getting your way I'd say they are divided into several groups one group that most open and the most ambitious group want to be among the best they want to compete with the with the best in the west and they want you to help them get there and they want for example we just had the China Merchants Bank president here who's making speech elsewhere at the same time they want to come to orden they want to learn and that's the best kind of entrepreneur you want to align yourselves where they want to invest in them the second kind wants your money and wants you to go away give me your money and leave me alone I'll make you return is fine but it's very difficult to work with them and we don't want to work with people who don't welcome our involvement and the last kind are the local local guys who were slippery you know integrity challenged achievers high achievers they can do a lot but they would never change their their behavior they may be slippery and may be offering bribes they are successful they are you know they can make a ton of money but they're crooks one sentence learn as much as you can but to be more specific I think our industry private equity industry is still a subset of the the finance world the finance sector so you have to learn the finance 101 I think just looking at the people we've hired over the last 20 years people who have consulting backgrounds who have banking backgrounds with some operating exposure are the best because they think strategically they can offer financial advice remember we have to deal with the entrepreneurs who would not respect you unless you have something to add but you would never be as good as they are in their industry because they live and die in that industry so you have to know something about finance about financial markets about instruments about you know the fancy stuff about M&A so that you can add value and that's the only way you can gain respect and once you have their respect you're on the same terms with them you you you you can you can discuss and come to terms with them on important decisions which are key for the success of an investment thank you you

Channel: Wharton School

Views: 155,295

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Keywords: private, equity, class, finance, lecture, Warburg Pincus, Ken Griffin, Bloomberg, East Asia

Id: yqLs1xwfNKE

Length: 86min 9sec (5169 seconds)

Published: Sat Feb 19 2011