Until recently, investors seeking to profit from China’s breakneck economic growth rate—at 9.1 percent in 2004, it was among the world’s fastest—via direct foreign investments were required to plumb the depths of local business culture: live in-country or visit frequently, learn the language and play golf with government officials. To be the

TOP VIEW Even the most seasoned investors in China admit that sometimes a tale of financial adventure is their primary return. By working with private equity funds run by managers who have taken their lumps and cracked the guanxi network, select investors have enjoyed double and triple returns in recent years. But other avenues—such as stocks in Chinese companies and real estate—remain risky propositions. In all sectors, local insight is imperative.

first to hear of a prime business or land sale and successfully bid for it required investors to have a presence on the ground. But today, those who have been burned in the past, or who have no interest or skills to invest in-country, are taking a more conventional route. Instead of committing vast amounts of time and capital (and their reputations), they are outsourcing these risks—with fingers crossed—to investment firms run by experts like Hsu who know the terrain and have strong guanxi, which translates roughly as connections, though the word implies tight personal relationships and a large collection of owed favors on which to draw.

Seasoned Hands
Despite his extensive experience, Hsu admits he has lost his and his investors’ money on some deals, “but,” he adds, “not our shirts.” He barely recovered $10 million of his own money invested in real estate in Dalian and Shengyang that he sold in 2000 after a four-year slump in the market. However, last year, he tripled a $20 million investment he made in 2000 when he took a Hambrecht & Quist–backed Chinese microprocessing chip maker, Semiconductor International Manufacturing, public on the New York Stock Exchange.

Dan Carroll is another accomplished Sinophile who knows how to navigate the vagaries of the Chinese market and has the ability to turn near-defeats into successes. A managing partner at Newbridge Capital and its China fund, Newbridge Asia III, Carroll, a protégé of Hsu, negotiated a deal three years ago to pay $120 million for an 18 percent, controlling stake in a state-owned financial institution, Shenzhen Development Bank. Several months later, the Chinese government reneged on the deal, and then a second bidder emerged. It took a year of negotiations before San Francisco–based Newbridge was able to prevail over the other party and become the first foreign owner of a stake in a Chinese bank.

More recently, Newbridge made a $350 million investment in Lenovo Group to support its widely reported purchase of IBM’s personal computer business, a deal that came about strictly through personal connections that led to the chairman of Lenovo. “Be very, very selective,” says Carroll, who has been ultra-aggressive in his deals—overly so, according to some investors—and has demanded, since the Shenzhen bank debacle, that his firm maintain a significant degree of control either through a board seat or a management position. He focuses on financial services opportunities because the industry is undergoing deregulation and he believes this will yield a plethora of opportunities.

Among the private equity funds currently raising capital are Hsu’s Hambrecht & Quist Asia Pacific, as well as Newbridge Capital, Walden International, Crystal Capital, IGlobe Partners, Diamond Tech Ventures and KLM Capital.

Most private equity firms that targeted China during the mid-1990s were not terribly successful. At the time, the only investment channels were joint ventures or state-owned enterprises. The performance of China funds launched since the late 1990s, when the Chinese government began to allow private equity firms to buy controlling stakes in entrepreneur-led private companies, has improved. These newer funds are earning approximately 10 to 20 percent annually, on average, though of course their investors are hoping for the occasional blockbuster like Semiconductor International Manufacturing to justify their assuming the additional country risk when they can secure similar or better returns closer to home.

Renminbi Roulette
Venturing into China through the stock markets is on a par with a weekend at the casinos in Monte Carlo, but not nearly as scenic. Some attractive stocks exist among those owned by private parties (as opposed to the Chinese government, which owns many of the country’s largest companies) and that have passed the regulatory requirements to trade in the West as American Depository Receipts or Global Depository Receipts. (See “Taking Stocks,” below.) Lenovo, an interesting specimen to overseas investors since its successful $1.75 billion bid for IBM’s PC unit last December, holds promise. The purchase has been expensive for Lenovo, one of the largely nongovernment-controlled mainland companies listed on the Hong Kong Stock Exchange, and concern over it has brought the share price down approximately 15 percent. But its stringent cost-cutting measures may pay off in the longer term. 

Shares of many of the companies recently listed on the  New York and London exchanges are trading lower than their initial prices, the companies and their shareholders apparent victims of pre-IPO hype by the investment banks that underwrote them, as well as growing pressures on profit margins caused by increasing competition in China.

Indeed, over the past year, Chinese stocks have been among the world’s poorest performers. H shares are trading 45 percent lower than their peak 10 years ago, and red chips are 70 percent off their highs of seven years ago. Performance of the Shenzhen and Shanghai stock exchanges has been even more moribund. Since 1993, A shares have risen only 3 percent in Shanghai and 2 percent in Shenzhen. Lee Branstetter, an associate professor at Columbia University Business School who has performed a detailed analysis of China’s equities markets, blames the lackluster performance on regulations restricting listings to underperforming state-owned enterprises.

Venturing into China through the stock markets is on a par with a weekend at the casinos in Monte-Carlo, but not nearly as scenic.

Those fearless investors who wish to wager on Chinese stock-picking should first secure a competent advisor. One good source of discerning appraisals of Chinese stocks, as well as of private equity and real estate investment opportunities, is the monthly China Investment Newsletter, published by the independent research firm Abacus Consulting Services, which has offices in Beijing and Alhambra, Calif. Abacus’s newsletter is no starry-eyed tip sheet. The firm cautions: “As state-owned and private companies use listing in the stock market as a tool to take money out of investors’ pockets, many fraudulent companies report false earnings and boast the popularity of their products to innocent investors.”

All Roads Lead to Equity
part from private equity and straight stock-picking, investors seeking exposure to China can look to exchange traded funds, hedge funds and mutual funds. However, they are all dependent on the whims of the country’s equity markets, because China lacks both bond and derivatives markets. This means that all investments in Chinese securities are, at bottom, equity based, and the market risk, absent any way to diversify it away, is nearly impossible to hedge.

The lack of derivatives markets makes what would otherwise be a playground for hedge funds a risky proposition. The fact that the same companies’ stocks may trade at different prices on different markets is a boon for arbitrageurs. However, the limited futures and options at their disposal makes it difficult to hedge against a broad market downtick, and so such funds are far, far more volatile than most of their counterparts in the West.

Still, there are success stories. JP Morgan Chase provides access to the Jayhawk China fund, run by Kent McCarthy, who has $32 million of his own money in the $240 million vehicle. He buys B shares directly in China and hedges them on the Hong Kong Stock Exchange. McCarthy says that a few bad experiences with too much exposure to state-owned enterprises taught him to hold his B shares down to 15 percent or less and trade more in American Depository Receipts. Partly by betting that certain U.S.-listed stocks will fall in value after their initial offerings, he generated returns of 15 percent early this year, until fears of a recession and currency revaluation rolled back those gains, McCarthy says. On average, however, the fund has risen 28 percent annually since 1999.

Others see too much risk in the domestic exchanges. Kai Shing Tao is a Taiwanese citizen who started a Greater China hedge fund called Pacific Star Partners last year, sponsored by U.S.-based KST Capital. Tao is eschewing the mainland stock markets altogether in his fund, buying instead into Hong Kong–listed red chips and other Asian companies that trade on the HKSE, where price-to-earnings ratios are about 30 to 40 percent less than for American-listed companies in general. The fund enjoyed a solid first 12 months, before dipping 5 percent this year.

For those seeking more liquidity than private equity or hedge funds offer, exchange traded funds (ETFs) boast the greatest ease of execution. They provide a taste of the China market for those who want to invest small amounts of money—and all too often, lose it. A handful of the existing pan-Asia, ex-Japan ETFs posted gains of 20 to 30 percent over the past year, spurring excitement over the prospect of the first all-mainland China ETF, the China 50, launched in February with State Street and China Asset Management as its sponsors. Unfortunately, the fund, which tracks the Shanghai-50 A-share index, slid by more than 9 percent in its first five months. An ETF with the unwieldy moniker PowerShares Golden Dragon Halter USX China Portfolio tracks an index of U.S.-listed Chinese stocks, and it, too, has stumbled. Initially listing at $15 a share late last year, it ended June down about 8 percent. Apart from the obvious risks of investing in Chinese stocks, passive vehicles like ETFs, especially those that track such small numbers of equities, are at the mercy of the markets—no experts stand ready to bail investors out of a plummeting stock. For this reason, they are much riskier than the type of broad-index ETFs normally used by investors.

Compare their performance with the active approach taken by the San Francisco–based Matthews China Fund, an equity mutual fund founded by veteran Asia money manager Paul Matthews. It managed to post annualized returns of 16.2 percent during the past three years before falling 1.77 percent as of late May. Like most China investments, the $850 million fund is extremely volatile; it plunged 40 percent in the spring of 2004. But in a universe where instability is the norm, Lipper, Reuter’s analytical division, ranks it the top-performing China regional fund for the five years ending May 31. The fund’s success seems to stem largely from seeking dominant companies in growth industries—and from the fact that among its top holdings are some well-established companies based in Hong Kong, including Swire Pacific and Bank of China.

All securities in China are, at bottom, equity based, and the market risk, absent any way to diversify it away, is nearly impossible to hedge.

Most of the excitement over China is predicated on its growth, but there are those taking a more contrarian approach. In the urban real estate market, a notorious bazaar where only true insiders should venture, Alexander Shang, a partner with the private equity firm Phoenix Capital Partners in New York and Beijing, is looking not to the boom, but to the bust. He has begun raising a fund to invest in distressed real estate; he plans to build out the interiors of buildings left as shells by bankrupt property developers. While he has not specialized in real estate before, he believes his extensive China experience gives him a 50-50 chance of turning others’ downsides into an upside. Shang says he has already spotted one likely opportunity: a huge real estate project left abandoned in the bustling southern Chinese manufacturing center of Shenzhen.

Those who have invested successfully in China share one trait in common: access to exceptional local knowledge. With this in mind, private investors looking to profit from the country’s boom would do well to do hire only the most experienced, active managers—which will usually lead them to the private equity community. Juan Meyer, executive vice president at the Greenwich, Conn., branch of the multifamily office Asset Management Advisors, agrees. “The only avenue we have found that makes sense is private equity,” he says. His family office invested 10 years ago in China Management, a $250 million private equity fund that has stakes in 27 fast-growing Chinese consumer companies. His firm’s capital in the fund has doubled in the past four years, primarily from returns garnered through public listings. Of the limited options, private equity offers the highest returns and lowest risk, he notes.

Taking Stocks 

Chinese corporations that sell securities abroad have to pass muster with local regulators in the countries where they list. However, investors should be particularly cautious, even when investing in Chinese companies listing in the U.S. or Europe. Sometimes what is listed as an American Depository Receipt or Global Depository Receipt is actually the stock of a holding company that has a contractual relationship with a Chinese company, meaning it is not necessarily a pure play on the performance of the company.
 
Chinese companies nominally adhere to International Accounting Standards, the rules developed by the London-based International Accounting Standards Board that are used in many European countries. However, whether government or privately owned, they are notorious for accounting irregularities. Also, the domestic market’s efficiency and fairness is hobbled by widespread insider trading, though technically this is illegal.

Many companies do list both at home and abroad, and their stock price can vary from one exchange to another at any given moment. The main instruments used by Chinese corporations to raise equity capital are:
 
ADRs: American Depository Receipts, traded on the NYSE;

GDRs: Global Depository Receipts, traded largely on the London Stock Exchange;

Red Chips: Hong Kong–incorporated entities doing business in China;

A Shares: Renminbi-denominated shares on the Shanghai and Shenzhen stock exchanges, open only to domestic traders and a very select list of foreign institutions;

B Shares: Foreign currency-denominated shares on the Shanghai and Shenzhen stock exchanges, open to foreign traders;

H Shares: Stocks of companies incorporated in China and listed on the Hong Kong Stock Exchange and foreign exchanges, such as Singapore.

Values Revalued

Those looking to invest in China should consider how a revaluation of the yuan—also known as the renminbi or “people’s currency”—would affect returns. (The official listing for the currency is CNY, although RMB also is correct.) One sector likely to be an instant—albeit short-lived—beneficiary is the flashy, but capricious, property market. The prospect of a stronger renminbi has created a veritable feeding frenzy for swanky Shanghai apartments in developments with Manhattan-sounding names such as Sohu and Century Park.

The prices of luxury residences in Shanghai have risen by as much as 40 percent in each of the past three years. They stabilized briefly this year after the government, seeking to contain speculation before the market imploded, placed capital gains taxes of 5.5 percent on property held less than one year. It also boosted the requirement for down payments from 10 to 30 percent of purchase price. These measures might be able to temper the short-term gains of a stronger renminbi.
 
Currency specialists predict that Beijing could revalue the renminbi within the next two years. David Gilmore, a partner at Foreign Exchange Analytics in Essex, Conn., believes the first step would be giving the renminbi a new exchange rate, but one that is still pegged to the dollar, or perhaps even the yen or euro. It is likely to be years, he says, before the renminbi is available as a freely traded play in the currency markets. “That is a political move and will happen when it happens,” Gilmore says. Even a slightly stronger renminbi, though, would make Chinese exports pricier and thereby change the dynamics that support the economic boom. However, the best Chinese companies realized years ago that the weak-renminbi, export-led business model would not last, and have moved to provide products that have more added value.

Rebecca Fannin is a New York–based freelance writer who writes frequently about Asia and the global private equity industry.