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KinetiCapital Monte Jade Semina 2005

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Published on November 16, 2007

Author: Freedom

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Slide1:  CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Monte Jade New England Seminar IV 4 June 2005 Brian Liou KinetiCapital K I N E T I C A P I T A L Slide2:  China is so big that whatever your theory is, it is true somewhere. China scenario AGENDA:  AGENDA CONTEXT Major Myths & Facts Why China Matters? RISK & OPPORTUNITY Investment Risks Investment Opportunities STRATEGY General Strategy – How to invest? Private Equity Investment Strategy A Short Film Slide4:  MYTHS & FACTS CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Slide5:  MYTH 1: Fortune Cookies Myth 1: Fortune cookies are from China:  Myth 1: Fortune cookies are from China Source: China Town Fact – No, you won’t see these cookies in China. What we take for granted here may not be true in China. Slide7:  MYTH 2: Foreign Direct Investment Slide8:  China is currently the world’s largest recipient of FDI Cumulative FDI in China, 1982-2003 Source: Strategy: China Expert Series, Deutsche Bank, March 2004 Myth 2: Massive FDI creates the China miracle Fact: FDI is surging, but only contributes less than 4% of GDP:  Fact: FDI is surging, but only contributes less than 4% of GDP Source: China - Market today, threat tomorrow, Goldman Sachs, 22 June 2004. Most of the China miracle is internally driven by state-sponsored infrastructure investment:  Most of the China miracle is internally driven by state-sponsored infrastructure investment In three years, Chinese capital expenditure has doubled and construction spending trebled. Source: Global Strategy – Market Cycles, SG Equity Research, May 2004 …. which accounts for 40% of GDP:  …. which accounts for 40% of GDP Source: China 2004 Strategy, CSFB, 05 Jan 2004 Slide12:  MYTH 3: Bad Dabts Myth 3: Bad debts will kill China:  Myth 3: Bad debts will kill China Source: Financial Risks in the Chinese Economy, Deutsche Bank, June 2004 Non-performing loans of state-owned commercial banks, 1994 and 1997 Fact: NPLs have been significantly brought down:  Fact: NPLs have been significantly brought down Source: Financial Risks in the Chinese Economy, Deutsche Bank, June 2004 Non-performing loans of state-owned commercial banks, 2001-03 Slide15:  Source: Financial Risks in the Chinese Economy, Deutsche Bank, June 2004 Bank of China non-performing loans, 2000-2003 NPLs — It seems the Chinese government “got it” International competitiveness is taken completely seriously, as is the 2007 agreement for full banking system opening, required by WTO membership in December 2001. Last year the China Banking Regulatory Commission (CBRC) was created, which required China Construction Bank (US$ 415 billion in assets) and Bank of China (US$ 375 billion) pilot in reaching very specific traditional Western ratios by 2005, including 60 basis points ROA, 11% ROE, 35-45% expense/revenues, NPAs under 5%, reserves 80% and 60% respectively, and 8% capital. And IPOs of these two banks on NYSE are by no means certain. Slide16:  MYTH 4: It’s Too Hot Myth 4: China is overheating:  Myth 4: China is overheating Restrictions on borrowing Limits were imposed on borrowing to certain industry segments, such as the steel, building and automotive industries. As a result, banks were instructed to limit the increase in borrowing to 16% in 2004. Increase in obligatory reserves China's central bank, the PBOC increased commercial banks' obligatory reserve ratio from 7.0% to 7.5% from 25 April 2004. Another possible measure would be a hike in base rates, mooted by the central bank in April. Halt to investment in certain sectors On 30 April 2004, the impetus gathered pace and all new investments in the steel, aluminium and cement industries were frozen until the end of the year. Source: China -- do you believe in miracles? ING Financial Markets, June 2004 Fact: Various measures have been adopted to avoid unchecked economic growth Slide18:  MYTH 5: Your Chinese Best Friend Myth 5: Partnership with Government is key to success:  Myth 5: Partnership with Government is key to success Lesson from the history -- Suzhou Park In 1992, a $20-billion, 70 sq km (tenth the size of Singapore) Suzhou Industrial Park near Shanghai was built by the governments of China and Singapore – a perfect formula of Singapore savvy, Chinese resources, and foreign money. After a few months, just 80 km northwest of Suzhou, Wuxi local government and Singapore Technologies built another Wuxi Industrial Park. Suzhou is a central government project, a Beijing-Singapore affair, therefore the cooperation between Singapore and the local government has not been as smooth as in Wuxi, which is a project between Singapore Technologies and the local government." Fact: In this land of opportunity, competition is everywhere. Lesson: Watch out for your competitors, AND the governments. Source: Lion and Dragon, Asia Week, 21 June 1996 Slide20:  WHY CHINA MATTERS? CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Why China matters?:  Why China matters? Current US dollar GDP has China as only the sixth-largest economy…. Source: World Bank. CDFB research. China 2004 Strategy, CSFB, 05 Jan 2004 Largest 15 global economies by 2001 GDP (current US$) But on the PPP* basis ….:  But on the PPP* basis …. China is already the world’s second-largest economy, and around 65% the size of the US economy. * Purchasing Power Parity. According to CSFB analyses, PPP is a more accurate way of making inter-country comparisons of physical output, free of price and exchange-rate distortions. Since lower local prices for non-traded goods and services allow real spending power to be available in much larger amounts for internationally traded and priced goods and services. Largest 15 global economies by 2001 GDP (current US$, PPP) Source: World Bank. CDFB research. China 2004 Strategy, CSFB, 05 Jan 2004 Why is China undervalued?:  Why is China undervalued? External policy of currencies China has consciously devalued their currencies ($1 = rmb 8.28) since the early 1990s to stimulate export-led growth. It is therefore no accident that China is the principal beneficiary of the current wave of outsourcing in manufacturing and services. Internal relocation of Human Resource Because of the significant disconnect between PPP and market exchange rates, high-quality local labors can be offered jobs at wages which simultaneously (1) undercut labor rates in the advanced economies, drastically, and (2) offer attractive increments for those labors moving to value-added industries. Source: China 2004 Strategy, CSFB, 05 Jan 2004 Market expectations have shifted to RMB appreciation:  Market expectations have shifted to RMB appreciation Source: CEIC, UBS. China: The Big Calls For 2004, UBS, Jan 2004 RMB forwards have shown the market expectations of currency appreciation but how about the GDP on US dollar basis?:  but how about the GDP on US dollar basis? Source: China's Emergence Transforms the Business World, Gartner Research, 28 April 2004 Greater China Conference 2004: Japanese Perspectives, UBS Global Research, Feb 2004 After 3 years, China will become the fourth-largest economy in the world (after the US, Japan and Germany), measured in terms of US dollars. Japan and China would have equivalent nominal GDP in 12 years (2016). The gap between Japan and China would disappear soon, and China will become the second largest economy by 2016. With US, China is expected to create a multi-polar economic world order defined by Beijing and Washington, D.C. in 10 years. China's emergence as a global superpower is one of the most important trends of the early 21st century. Key data: about 500 million urban population:  Key data: about 500 million urban population Source: Oxford Economic Forecasting, March 2004 Hourly wage is competitive:  Hourly wage is competitive Source: Oxford Economic Forecasting, March 2004 Comparison of hourly wage costs in manufacturing (US$) 80% of public companies are SOEs:  80% of public companies are SOEs Source: Oxford Economic Forecasting, March 2004 US$404 billion of Foreign Exchange Reserves:  US$404 billion of Foreign Exchange Reserves Source: Overview of Portfolio Investment Opportunities in China, Morgan Stanley, April 2004 Industrial production is extremely robust:  Industrial production is extremely robust Source: China 2004 Strategy, CSFB, 05 Jan 2004 Income growth fuels the consumption:  Income growth fuels the consumption Source: China 2004 Strategy, CSFB, 05 Jan 2004 Capital spending is booming:  Capital spending is booming Source: China 2004 Strategy, CSFB, 05 Jan 2004 High savings ratio, a bright spot in China:  High savings ratio, a bright spot in China While nominal GDP in 2003 rose almost 30x compared to 1978, household savings deposits rose by 500x. Strong Funding from Internal Savings (US$ 1.6 trillion) represents an enormous, self-reliant source of capital. No other emerging market has such an internal foundation for funding future growth. Source: CEIC. China Market Strategy, CSFB, 11 June 2004 The China Factor, Sandler O’Neill Investment Strategy, 17 June 2004 40% of savings rate:  40% of savings rate Source: China 2004 Strategy, CSFB, 05 Jan 2004 Service sector is underserved:  Service sector is underserved Source: China 2004 Strategy, CSFB, 05 Jan 2004 Services as a % of GDP for major developed and emerging economies China has been the dominant individual contributor to global growth in recent years :  China has been the dominant individual contributor to global growth in recent years Source: China 2004 Strategy, CSFB, 05 Jan 2004 Industrial Production: Global vs. China China was responsible for half the growth in global trade in 2002 :  China was responsible for half the growth in global trade in 2002 Source: China 2004 Strategy, CSFB, 05 Jan 2004 China’s contribution to global trade growth % A major driver of global GDP growth:  A major driver of global GDP growth Source: China Tech A Shares, UBS, 12 Feb 2004 China GDP growth vs. global growth Upcycle after WTO:  Upcycle after WTO Source: China 101, JP Morgan Research, 12 Feb 2004 Upcycle due to investment and consumption:  Upcycle due to investment and consumption Source: China 101, JP Morgan Research, 12 Feb 2004 Profit upturn due to strong supply and demand:  Profit upturn due to strong supply and demand *Similar analyses can be found at China Strategy, Morgan Stanley, Feb 2004, page 33 Source: China 101, JP Morgan Research, 12 Feb 2004 The largest manufacturing powerhouse, globally:  The largest manufacturing powerhouse, globally As machine tool demand tends to be an accurate proxy for manufacturing capacity, In 2002 for the first time, we see China emerging as the most important manufacturing hub, globally. Source: China 2004 Strategy, CSFB, 05 Jan 2004 Shift of global manufacturing capacity: Tool machine demand (US$mn) Slide43:  RISKS CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Slide44:  Major Risk Factors in China [Risk 1] Consumption grows slower than the capital investment :  [Risk 1] Consumption grows slower than the capital investment Source: What has happened to the China story? UBS Investment Research, April 2004 [Risk 2] Urbanization creates more social issues:  [Risk 2] Urbanization creates more social issues Source: A Visitor’s Guide to China, UBS Investment Research, January 2004 1% increase in urbanization ratio = 13 million residents in cities Social issues:  Social issues The wage gap has widened rapidly in the past decade. Wealth gap has also widened, partly due to the stock market and housing reforms (privatisation). Unemployment rate is estimated at 10% and is likely to rise further. Pressure on urban housing, energy, and education. Corruption and social discontent. Source: What has happened to the China story? UBS Investment Research, April 2004 [Risk 3] Inflation has been high for two decades:  [Risk 3] Inflation has been high for two decades Source: A Visitor’s Guide to China, UBS Investment Research, January 2004 [Risk 4] Hard-landing in China can hurt the whole world:  [Risk 4] Hard-landing in China can hurt the whole world China’s track records of selective tightening policies to slow the investment can be the major risk concern for global investors in the near term. China’s complex dynamics with global economies may hurt the world should a hard-landing happens. Should China slows 10% of investment in 2004, it would only reduce 3% of its GDP, but significantly hurt the rest of the world -- from 5% of US, 9% of Japan, 40% of Singapore, to 50% of Hong Kong (Citigroup Smith Barney analyses). Source: Greater China Insights, Citigroup Smith Barney, May 2004 [Risk 5] Population growth still the issue:  [Risk 5] Population growth still the issue Source: What has happened to the China story? UBS Investment Research, April 2004 [Risk 6] Oil demand is soaring:  [Risk 6] Oil demand is soaring China now also drives changes in global oil demand. Until 2000, the increase in oil demand was coming principally from the OECD economies. But since 2001, the increase in demand from China has exceeded the increase in demand from the whole of the OECD. Source: China sneezes, the world catches a cold. SG Global Strategy, 25 June 2004 ….and China’s oil shortage is likely to worsen :  ….and China’s oil shortage is likely to worsen Source: What has happened to the China story? UBS Investment Research, April 2004 [Risk 7] IT is still a big story…. :  [Risk 7] IT is still a big story…. China is the world's leader in the mobile handset market. The world’s second largest PC market is in China. By 2007, China will become the world’s largest Internet subscriber market. (0.8 probability, Gartner Research April 2004). Source: Foreign Companies Face Unique Challenges in China, Gartner Research, April 2004 ….but Foreign Companies Face Unique Challenges:  ….but Foreign Companies Face Unique Challenges Few Chinese consumers have adopted online buying habits. Government regulations limit access to Chinese consumers. China's size and culture make marketing extremely challenging. Operational costs in China often exceed enterprises' expectations. China has a shortage of capable, qualified managers. China lacks financial information intermediaries and systems. Competition is intense in all Chinese IT industry sectors. Foreign businesses find it difficult to navigate through the Chinese government and legal system. Source: Foreign Companies Face Unique Challenges in China, Gartner Research, April 2004 Slide55:  Sustaining strong growth requires the reform from the bureaucrats to the markets. But currently in China, private investment is reportedly not permitted in 30 industries including telecom, banking, railways and various products in other industries. Major entry barriers restricting private activity include 1) licensing requirements, 2) government policy restrictions, 3) local market protections, and 4) monopolies. A recent study found that the key entry barriers for private sector firms are licensing requirements and government policy restrictions. [Risk 8] Regulation is the key barrier in private sector Slide56:  How Risky is China? China country risk assessment:  ¹ Composite of political, financial, and economic risk Source: International Country Risk Guide, The PRS Group, Inc. 2004 China country risk assessment How risky is China?:  How risky is China? Are emerging markets riskier than developed ones? Not if you take a portfolio perspective on corporate investments. Source: The McKinsey Quarterly, 2003 Number 4 Slide59:  OPPORTUNITIES CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Opinion leaders in China trust the government -- an easier environment for policy makers to make changes:  Opinion leaders in China trust the government -- an easier environment for policy makers to make changes Source: Business China, The Economist Intelligence Unit, April 26, 2004 Slide61:  The Chinese Government has continued its strong commitments to economic reforms, including Corporate governance, Capital allocation, Disposal of NPLs, and Privatization. …. and the Government has strong commitments to transform China Source: Portfolio Investment Opportunities in China, Morgan Stanley, April 2004 Massive infrastructure potential:  Massive infrastructure potential Infrastructure in China is likely to develop significantly over the next few years, driven by: • Urbanization of provinces. Close to 345 million people are likely to move from rural areas to urban centres over the next 20-25 years in China. The Chinese urban population will reach 800 million by 2020, compared with 502 million in 2003. • The “Go West” programme. Similar to the approach adopted by Beijing authorities to encourage migration of rural populations to urban centres out to 2020, the government introduced a programme two years ago to facilitate investment in the west of the country, a region that is being somewhat left behind. The current level of urbanization is extremely low, at 39%, equivalent to the level seen in the US in 1911 and in Japan in 1950. This programme includes tax incentives and more flexible administrative procedures for investors seeking to invest in the west of the country. By benefiting from these incentives, companies could address tight labor market problems in cities such as Beijing and Shanghai, where staff turnover is currently in excess of 20% pa. • Hosting the Olympics in 2008 and the Universal Exhibition in 2010. These two major events are likely to lead to a significant increase in the country’s infrastructure requirements, particularly in Beijing and Shanghai. For example, Beijing is to disburse more than US$30 billion by 2008 for infrastructure in its broadest sense (ie, including building roads, sports stadiums and metro lines). Source: China -- do you believe in miracles? ING Financial Markets, June 2004 Tax reform required by WTO will benefit investors and customers:  Tax reform required by WTO will benefit investors and customers Heavy capex spenders may benefit. Change in the assessment bases of value added taxes from a production-oriented tax to a consumption-based tax, which can encourage more investment in R&D and facilities upgrading to improve long-term competitiveness -- exemption from VAT may be granted to production facilities and reduce the investment cost. Disposable income & consumption to rise. Current personal income tax rates have been effective since 1994. During the period from 1994-2003, China’s inflation rose by an average of 32%. If China is to encourage consumption, it needs to raise the personal tax allowance from the current Rmb800 per month (to at least Rmb1,000) and reduce the effective tax rates in each tax bracket to maintain the real purchasing power of the population. This would effectively raise the disposable income of individuals and boost consumption. Source: China Strategy, Investment outlook for 2004, ING Financial Markets, December 2003 China Strategy Quarterly Q204, UBS, March 2004 Slide64:  State-Owned Enterprise Opportunities WTO requirements help predict which policies may change :  WTO requirements help predict which policies may change SOE reform to sell some crown jewels In the coming year, China is expected to hasten SOE reforms and encourage more SOEs to list on the stock markets. This would allow the enterprises to raise funds to finance expansion and become more competitive. Furthermore, there will be more liberalisation to allow foreign and private enterprises to take over SOEs or participate in the management of an SOE through equity ownership. There is an increasing number of foreign enterprises looking at strategic stakes in China’s major SOEs and listed companies. Thus, the SOEs could surprise the market with new joint ventures, which may boost income prospects. Source: China Strategy, Investment outlook for 2004, ING Financial Markets, December 2003 China Strategy Quarterly Q204, UBS, March 2004 Windows of opportunity with private companies in China:  Windows of opportunity with private companies in China Jing Ulrich Managing Director Head of Greater China Equities Deutsche Bank Source: Strategy: China Expert Series, Deutsche Bank, March 2004 Final transition in moving towards a market economy “The government is finally pushing the private sector, whereas when I arrived people didn’t even say private sector in meetings, they said non-state and other euphemisms. Now people are actively wanting to meet me and encouraging us to come to their cities to put more money into their private sector. So we see this really as a final transition for China towards a market economy. We therefore feel we have sort of a window of three to five years where there are real opportunities to make investments that will hopefully pay off in the future. As I said, these opportunities come in areas of privatization.” SOEs have controlled a major portion of Chinese economy:  SOEs have controlled a major portion of Chinese economy Source: National Bureau of Statistics of China; Legend Hon-Y Capital 2004 SOE’s control a major portion of resources Assets of enterprises (2002) No. of listed companies (2001) SOE’s Non-SOE’s 52% 80% 48% 20% SOE’s dominate major industries in China Financial Institution Oil & Energy All major banks and insurance companies are SOE's Dominated by PetroChina, CNPC, China Guodian, etc. Auto-motives Dominated by FAW, SAIC, Dongfeng, etc. Telecom services Dominated by China Telecom, China Netcom, China Mobile, Unicom, etc. Pharma-ceuticals Most top local players are SOE's, e.g. NCPC, Hayao. % of …. but SOEs have significantly underperformed the private companies:  Asset & Productivity Comparison of SOE’s vs. Non-SOE’s in China, 2002 …. but SOEs have significantly underperformed the private companies Share of Total Assets GDP Contribution SOE’s Non-SOE’s 52% 30% 48% 70% Potential Efficiency Improvement for SOE’s Tighter control on SG&A Downsize Write off non-performing assets Optimize capital structure Re-engineer business process Introduce performance based management incentive system Source: National Bureau of Statistics of China; Legend Hon-Y Capital 2004 Slide69:  The 16th Communist Party Congress in 2002 made it a policy that state owned assets must exit from all non-strategic industries, kicking off massive SOE privatization in China For example: Jiangsu Province announced to sell 200 SOE's with total asset value of US$10 billion Shanxi Province announced to sell 500 SOE's with total asset value of US$6 billion Government is committed to the privatization of SOE’s SOE restructuring represents a window of opportunity Arbitrage opportunities via Low cost entry Favorable government policy on asset write-off and employee assistance Net asset based valuation methodology Value creation via Incentive system injection Operation improvement Capital restructuring Consolidation Source: National Bureau of Statistics of China; Legend Hon-Y Capital 2004 Capital market activities are picking up….:  Capital market activities are picking up…. M&A volume & size(Jan-Nov, 2002) among domestic listing companies (‘CNY Million) Number of listed Chinese companies (Domestic & international exchanges) Source: National Bureau of Statistics of China; Legend Hon-Y Capital 2004 ….with more value in the market:  ….with more value in the market Source: China Strategy Quarterly, UBS, 7 Jan 2004 Policy direction and general investment themes :  Policy direction and general investment themes In 2004-2005, China will speed up the pace of reform to prepare state-owned enterprises (SOEs) and the financial sector for full market liberalization. Investors need to position ahead of the possible policy changes and trends to optimize gains. China’s major trends and possible policy changes in 2004-2005 will aim at increasing productivity and competitiveness for SOEs. Reforms in taxation, SOEs, financial markets, and the rural sector may surprise the market. China will strive to maintain an investment-friendly environment to raise funds and restructure the SOEs. Auto and consumer sectors will be key attractions, underpinned by high income growth, rising consumption and accelerated urbanization. What is defensive? Export-oriented and consumer industries are also the most defensive sectors should the Chinese authorities slowdown the economy. Source: China Strategy, Investment outlook for 2004, ING Financial Markets, December 2003 China Strategy Quarterly Q204, UBS, March 2004 Downside protection of investment: Nondurable is strongly Recession-proof:  Downside protection of investment: Nondurable is strongly Recession-proof Durable versus Nondurable Goods Orders year-over-year percentage change based on 12-month rolling average in US Note: shading indicates recession. Source: Monthly Retailing Register, CSFB, November 2003 crash Stable Recession-proof High risk Cyclical Slide74:  “Greater China” Opportunities The “United States of China” in Economy:  The “United States of China” in Economy China Large skilled labor pool and cost-effective engineering talent Education and training Domestic market Taiwan R&D/Manufacturing Global supply chain expertise Established outsourcing partnerships with MNC’s Experienced managerial talent Hong Kong Mature capital market Marketing and sales know-how Experienced trading expertise built on the same/related: Culture, Language, Family, Education, Business Source: “Greater China” cover story, Business Week, December 9, 2002; Crimson Ventures 2002 Greater China -- Economic integration via investments:  Greater China -- Economic integration via investments Same language/culture have enabled Taiwan/Hong Kong companies to shift business to China, injecting technologies and management experiences. 47% of the top 1,600 Taiwan companies (based on 2000 revenues) have already set up at least one subsidiary in China. Cumulative Foreign Direct Investment from Taiwan, Hong Kong to China (US$ in Millions) 21% CAGR Source: Ministry of Foreign Trade and Economic Cooperation, PRC; Crimson Ventures 2004 How do foreign investors leverage the Greater China Market?:  How do foreign investors leverage the Greater China Market? As a growing domestic market BenQ, owning the channel, is now the leading brand name in China for CD-ROM drivers/keyboards as well as scanners/monitors. Leverage China Market As a manufacturing center for exporting goods to global markets Giant manufactures bicycles in China primarily for Japan and other markets and enjoys savings on labor, operating and component cost. As a “secondary” market for production flexibility PouChen, manufacturing shoes for Nike, produces primarily for the US market but also has the flexibility to sell to the China market. Source: Crimson Ventures 2004 Slide78:  STRATEGY How to choose a sector? CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS China’s one-way valve for capital:  China’s one-way valve for capital Capital in China is not free to chase returns. The minute it enters the market, it is classified by origin, namely: government capital, which has exposure to almost all opportunities; foreign capital, which has exposure to most investment opportunities since China joined the WTO, but in many cases can be only passive; domestic private capital, which has no global or upstream investment opportunities. Foreign capital overflow to the downstream sectors ends up in combat with domestic private capital. While foreign capital is net inflow anyway, the valve traps most government and domestic private capital onshore, forcing this capital to chase limited opportunities. Source: China Strategy, Morgan Stanley, 25 June 2004 Slide80:  EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? Criteria: DEMAND SUPPLY COMPETITION POLICY Slide81:  AUTO INDUSTRY 1. DEMAND ANALYSES EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? China Automobiles:  China Automobiles Watch Out for China -- Four Reasons Why China Is Important: – China is the 4th largest auto market – China is the fastest growing market, globally – High Profitability – Export potential – Components Sourcing China Means: – 34% of VW’s 2003 group profit – 15% of GM’s 2003 group profit – 7% of Honda’s 2003 group profit Source: China Auto Industry Update, Morgan Stanley, June 2004 Auto Demand growth continues in 2004:  Auto Demand growth continues in 2004 China Historical Car Sales Volume (K units) Source: China Auto Industry Update, Morgan Stanley, June 2004 Auto Industry:  Auto Industry China can have a very substantial pick-up in vehicle density as the population’s income grows. Analyses suggest that current vehicle density of around seven vehicles should grow to 8 in 2003, 13 by 2007 and 42 by 2018. Source: China 2004 Strategy, CSFB, 05 Jan 2004 Booming sector, but still at very early stage:  Booming sector, but still at very early stage Source: JD Power; China 2004 Strategy, CSFB, 05 Jan 2004 Global vehicle density comparison (vehicles per 1,000 drivers) Slide86:  AUTO INDUSTRY 2. SUPPLY ANALYSES EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? Capacity rolls in China is no exception:  Capacity rolls in China is no exception Volkswagen plans for capacity of 1.6m units by 2006. Through 5 JVs, GM and partners plan 1.3m units. Boardrooms in US, Europe, Japan and Korea have come to the same conclusion: "We must win in China and we need to make victory by increasing our capacity – now!" Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Supply curve moving up:  Supply curve moving up Given recent new capacity expansion plans of MNCs, China’s car supply curve is pushed up slightly further By 2007, total design capacity to reach 7,710 units, representing a 32% CAGR from now. Change in MS Car Capacity Forecast (‘000 units) Source: China Auto Industry Update, Morgan Stanley, June 2004 Recent capacity landing:  Recent capacity landing May 2, 2004: VW’s Shanghai venture announced plans to construct new plant with designed capacity of 300K units. June 7, 2004: GM, together with Shanghai Automotive Group, announce plans to invest US$3 Bn in China by 2007 to further expand capacity from 400K units in 2003YE to 1300K units in 2007. More than 20 new models are already in the pipeline and to be launched to market within 3 years. Ford and Mazda plan to establish a new plant in Nanjing together with Chang’an Auto. Initial capacity to reach 200K units and production to start in 2006. Source: China Auto Industry Update, Morgan Stanley, June 2004 Auto labor force is extremely competitive:  Auto labor force is extremely competitive Highly skilled workers in China produce the hand-made luxury versions of the Jeep (to buyers in the Middle East, mostly) for $8,000 to $10,000. And the annual salary of these experienced workers in China is less than the monthly pay of new hires in Detroit. Source: The Chinese Century, The New York Times, 4 July 2004 Strong support from the infrastructure:  Strong support from the infrastructure One measure of just how big this boom is: China currently has more than 15,000 highway projects in the works, which will add 162,000 kilometers of road to the country, enough to circle the planet at the equator four times. Source: The Chinese Century, The New York Times, 4 July 2004 Slide92:  AUTO INDUSTRY 3. COMPETITION ANALYSES EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? Motorization: Making profits in China's Auto market A well-kept secret no more :  Motorization: Making profits in China's Auto market A well-kept secret no more Thanks to the voracious demand for big US$30,000 sedans, China is one of the most profitable places on earth to sell cars. GM made close to US$450m in 2003. VW, with sales 3x greater than GM, quietly made a bundle too. Again, it’s all about the low cost. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 The downside to rich profits – They draw a crowd:  The downside to rich profits – They draw a crowd Between 1998-04, the number of new models on the market has increased from 14 to 95. The Volkswagen Santana once routinely captured 20% of the market. Today, the best-selling model (Jetta) holds on to just 5% of the market. “Big Boys Party” – competition will be limited to current key players, including domestic ones. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Geely: from motorcycles to cars Strategy: build affordable cars for the masses:  Geely: from motorcycles to cars Strategy: build affordable cars for the masses Geely is a private company founded by Li Shufu, a self-made multi-millionaire from a farming town in Zhejiang Province. The company is expanding capacity to 200,000 units this year. Geely cars are priced from US$4,000-6,000. It saves money by duplicating car designs and parts already in the market for a long time. Sales are up 91% through the first four months of 2004. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Chery: a flower amid one of China's poorest provinces JV experienced leadership and a bolder approach :  Chery: a flower amid one of China's poorest provinces JV experienced leadership and a bolder approach In 2003, Chery (Qirui) shocked the industry when it unveiled the QQ, a car that bore extremely close resemblance to the Chevrolet Spark. QQ, priced at RMB55,000, has outsold the Spark, priced at RMB67,000, by a factor of 6 to 1 in 2004. The Chery Group sales, which now include four products, are up 118% through April, 2004. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Shijiazhuang Shuanghuan – 'two rings' Chinese brand – just borrowing from foreigners' good points :  Shijiazhuang Shuanghuan – 'two rings' Chinese brand – just borrowing from foreigners' good points South of Beijing, in a dusty city of about 1m, this pick-up truck maker is making a foray into the small SUV segment. Today, the sophisticated city buyers of the Honda CR-V are not likely to consider the Shuanghuan offering. Then again, competition is just getting started. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Point: as competition increases, Chinese firms will wilt More sophisticated buyers will demand the very best :  Point: as competition increases, Chinese firms will wilt More sophisticated buyers will demand the very best Greater Beijing, Shanghai and Guangdong are the largest markets in the country. Selling well here are world-class sedans like the Audi, Buick, Honda, Toyota and Volkswagen. Conventional thinking is that inland city buyers will soon buy the same products as their coastal richer cousins. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Counter point: as competition mounts, price will rule "Take the countryside and surround the cities" :  Counter point: as competition mounts, price will rule "Take the countryside and surround the cities" Will global auto makers find themselves limited to the big city markets, unable to compete inland on low price? Should GM acquire a private company like Geely, to secure the market share? These are the open questions. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Local competitors know How To Compete :  Local competitors know How To Compete That local competition, which sprung up "almost overnight," was particularly vexing. While MNCs had to learn the lay of the land and adapt business practices to the Chinese way of doing things, the native companies were able to exploit a dramatically lower cost structure and, most importantly, focus on customer needs. "Chinese companies don't have a legacy; these companies start with a clean sheet of paper". — Christina Zhu, Honeywell International An example, Zhu said, is Honeywell's business in turbochargers, equipment that increases engine performance. In the company's traditional markets, turbochargers have been purchased for use on heavy-duty trucks. But in China, the biggest market for turbochargers is in passenger cars. "We're still trying to figure that one out," Zhu said. Source: What It Takes to Succeed in China, HBS Working Knowledge, April 2004 What's the track record in other industries? Chinese firms learn quickly:  What's the track record in other industries? Chinese firms learn quickly From TVs to computers to cell phones to motorcycles, China has made full use of joint ventures to learn how to do things themselves. One of the biggest challenges facing Motorola and other global manufacturers is that Chinese suppliers are getting too good. Their quality, low-priced parts have helped create new, homegrown and extremely aggressive competitors. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 Slide102:  AUTO INDUSTRY 4. POLICY ANALYSES EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? Early signs of Auto market softness? The government hopes not:  Early signs of Auto market softness? The government hopes not On 1 June 2004, the State Planning Commission (SPC) issued the new automotive industry policy. One of the key items in the policy is the stipulation that local governments should do nothing to obstruct purchase of cars. Source: China Expert Series -- What happens five years from now? Making profits in China's car market. Deutsche Bank, June 2004 What’s New in the Auto Policy? :  What’s New in the Auto Policy? New localization Requirement -- Certain critical components must be localized, otherwise full whole car import tariff applies. Source: China Auto Industry Update, Morgan Stanley, June 2004 Slide105:  AUTO INDUSTRY 5. Conclusion Strong supply and demand lead to a larger market and more competition. Policy shows that the inefficiencies go to Auto Component sector, especially the Car Body and Power Train categories, which can be attractive for global private equity investors. EXAMPLE OF INVESTMENT STRATEGY How to choose a sector? Slide106:  Venture Capital & Private Equity CHINA STRATEGY FOR GLOBAL PRIVATE EQUITY INVESTORS Slide107:  VCPE Introduction Slide108:  Comparison of VCPE Investment and Commercial Banking VCPE Investment Commercial Banking Equity Liability Capital Gain Interest High Leverage No Leverage Lower Liquidity (generally long-term) Higher Liquidity (short-term to long-term) Business/ Operation Legal/ Credit Target Revenue Source Control Power Fund/Asset Leverage Target Liquidity Source: Investment Perspective from Venture Capitalists, Cliff Chen, Crimson Ventures, 2001 Slide109:  Global Capital Market: Private and Public Institutional Investors Individual Investors Private Equity Market Public Capital Market Venture Capital LBO / MBO Others Stock Exchange Private Companies Public Companies Public Capital Market IPO De-list Source: Venture Capital & Private Equity, A Case Book Harvard Business School, 2004 Slide110:  Comparison of VCPE Organizations Type I Type II Partnership Corporation Limited Evergreen Stock Dividends Capital Distribution Carry Interest / Management Fee Bonus / Management Fee Capital Distribution Capital Decrease / Liquidization Legal Entity Legalized Life Span Capital Exit for Investors Return to Investors Management Compensation Source: Investment Perspective from Venture Capitalists, Cliff Chen, Crimson Ventures, 2001 Why buildup operations with Private Equity? KinetiCapital example::  Why buildup operations with Private Equity? KinetiCapital example: Institutional Shareholder – Consolidate multiple Angel Investors to create a “single funding shareholder” structure. Stronger valuation position in the future. Deal Access – Easier to reach deals with investor status: searching for alliances, executives, and investment opportunities; not startup looking for support. Contract Simplicity – Independent from the complex China legal system. K I N E T I C A P I T A L China Operations Incubate / invest in China operations (with a simple, single institutional investor) Source deals Deliver deals Create value Suppliers / Customers Source: KinetiCapital, 2005 potential competitors Invest in / buy out potential competitors Angel Investors Slide112:  China VCPE Overview Overview of China’s VC/PE Industry & Key Players:  Overview of China’s VC/PE Industry & Key Players Source: Overview of Portfolio Investment Opportunities in China, Morgan Stanley, April 2004 VC/PE in China is still at very early stage:  VC/PE in China is still at very early stage The amount of private equity investment in China increased from $550 million in 1997 to $1.3 billion in 2003. Now a potential risk of investing in private equity and venture capital funds in China is that government regulations may still be difficult for private equity and venture capital investments to be realized through public stock offerings Source: Overview of Portfolio Investment Opportunities in China, Morgan Stanley, April 2004 Slide115:  Source: 2003 Guide to Venture Capital in Asia, AVCJ Group, 2003 China Disbursements to Industry (2001 Total: US$5,675 million) Most VC money in China went to Computer related sectors Slide116:  Approaches of Foreign Direct Investment in China Direct Local Co-investment Chinese government Chinese major companies Indirect International Co-operation for Local Networking Multi-national companies with Chinese relationships and operations International investment banks with Chinese footprints Portfolio Pioneering for Local Market and Networking Invest in off-shore companies with Chinese operations Encourage current portfolio to build Chinese operations Leverage the networking and experiences of portfolio companies for future direct investment until China transform into a clear environment for direct investment. Slide117:  Advices on VCPE Investment in China [1] Find a Good Partner:  [1] Find a Good Partner Put this at the top of your list. Find a partner who has already done VC deals in your field in China. Do NOT form joint ventures with the Chinese government or with government owned businesses. And three, partner with an indigenous Chinese firm (as opposed to one based in Hong Kong or Singapore) if you can. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [2] Get a Trans-Pacific Attorney:  [2] Get a Trans-Pacific Attorney The legal and regulatory environment is changing so fast that if you don't have strong legal counsel you are headed for trouble. And remember, every business or company you invest in must be an entirely legal entity. The short list of firms include Baker & McKenzie; Jones Day; O'Melveny & Myers; Heller, Ehrman, White & McAuliffe; Preston Gates; Shearman and Sterling. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [3] Avoid SOEs at the beginning:  [3] Avoid SOEs at the beginning Warburg's Chang Sun interviewed by VCJ warns new investors that while the signs are out for the world's largest garage sale and government assets are being sold at low prices, the value of such assets is frequently destroyed by managers involved in running former SOE companies. Don’t do SOEs without good connections, Hire someone from SOEs can be helpful, too. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [4] Put Feet on the Street:  [4] Put Feet on the Street So many venture capitalists are living on planes and out of suitcases. As they're among the most successful VCs, we never question their ability to make this work, and work well. But for long term success -- you better have someone on the ground in China to network, make deals, and know what is changing. Parking yourself in palatial Hong Kong offices doesn't work. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [5] Structure An Exit in Advance:  [5] Structure An Exit in Advance Consider how you are going to exit your investment from day one. Unless you're going to China for the long-term, this means investing via a Wholly Owned Foreign Entity. A WOFE is a wholly owned subsidiary of operating companies typically set up in the Cayman Islands or British Virgin Islands. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 Slide123:  WOFE for Foreign Direct Investment in China – Basic Example Source: Tax, Legal & Business Advisory, Deloitte; Investar Capital, August 2001 Foreign Investor BVI China Co. Functions of BVI entity: 1. IPO-exit entity 2. M&A-exit entity 3. Risk buffer (e.g. law suit …) Portfolio company operating in China “Indirect” FDI Slide124:  WOFE for Foreign Direct Investment in China – Advanced Example Source: Tax, Legal & Business Advisory, Deloitte, August 2001 Foreign Investor BVI 1 BVI 2 China Co. Capital gain is reserved in BVI 1 for: Further investment Distribution Deferring / Avoiding tax Functions of BVI 2: 1. IPO-exit entity 2. M&A-exit entity 3. Risk buffer (e.g. law suit …) Portfolio company operating in China [6] Be Patient :  [6] Be Patient To succeed in the world’s biggest growing market, you'll need a long-term outlook, flexibility, humility, and a non-confrontational operating style. In the aftermath of the Internet boom China's leading Internet portals, all backed by VCs, saw their stocks plummet. But after years of repositioning and hard work, many of those companies are back on track: Sina (Nasdaq: Sina) is at about $29, and Sohu.com (Nasdaq: Sohu) is at about $18, NetEase.com (Nasdaq: NTES) trades for about $38 a share. (as of 1 June 2004). Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [7] Get Ready To Rumble:  [7] Get Ready To Rumble Everyone faces the competition. Some of the challenges: the cost of capital is less for domestic Chinese firms and the model is skewed to local competitors by language and knowledge of the local market. If you're going to survive in China you must pick businesses with a high barrier to entry, otherwise you'll have competitors starting up the day after you hang out your shingle. Cisco found itself in competition with its manufacturing partner, Huawei. Cisco took the partner to court to protect its intellectual property, but in the end, dropped its suit. Today, Huawei finds itself in stiff competition with Harbour Networks, a Chinese company started up by a former Huawei executive. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [8] Choose the Right Location:  [8] Choose the Right Location There are Two Chinas. Go to “Rich China” where all the money goes to. Clearly, Shanghai is one of the places. China is as big as the United States. You don't want to add to your travel time within the country. If you're doing anything with infrastructure, telecommunications, finance or transportation, you need to be in Beijing, where you'll spend your time lobbying for business permits. Source: Rules of the Road, Venture Capital Journal, 1 June 2004 [9] Catch the right moment. US Venture Capital Investment is down since 2000 :  [9] Catch the right moment. US Venture Capital Investment is down since 2000 Source: 2004 Annual Venture Capital Insights Report, Ernst & Young VC Advisory …. same as the Israeli Venture Capital Investment :  …. same as the Israeli Venture Capital Investment Source: 2004 Annual Venture Capital Insights Report, Ernst & Young VC Advisory …. and the European Venture Capital Investment:  …. and the European Venture Capital Investment Source: 2004 Annual Venture Capital Insights Report, Ernst & Young VC Advisory Growing with the trend, Global VCPE investors can also diversify risks by pursuing China opportunities:  Growing with the trend, Global VCPE investors can also diversify risks by pursuing China opportunities Source: 2003 Guide to Venture Capital in Asia, AVCJ Group Annual Accumulated Venture Capital Disbursement in China [10] Know the rules in China::  [10] Know the rules in China: 1. Everything is possible. 2. Nothing is easy. 3. China is big, undervalued, and expanding. 4. Policy inefficiencies create space for profit making. 5. VCPE investment is still very early, Western rules don’t apply. 6. Everyone claims he/she has a strong Quan-Xi (connection). 7. When people say “basically, no problem,” you’ve got a problem. 8. Watch out for your partners and governments. 9. When things seem too easy, go to Rule No. 2. 10. When things seem too hard, go to Rule No.1. What are these posters for?:  What are these posters for? Slide134:  THANK YOU questions/suggestions please email to Brian Liou BLiou@mba2004.hbs.edu K I N E T I C A P I T A L

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