China's High-Tech Ambitions and Disappointments

China Survey 2014
New directions and new challenges
This proprietary research note is intended exclusively for use of the recipient. It contains confidential information.
All contents are copyright 2014 . www.chinafirstcapital.com ceo@chinafirstcapital.com

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China High-Tech: Giant
Ambitions Can’t Disguise
a Disappointing Record
of Achievement
“China, the innovation nation”. With nine times
more engineering graduates and more patents filed
each year than in the US, China is transitioning
quickly away from its roots as a copycat, knockoff
economy to become a potent new high-tech power.”
We’ve all seen the headlines, read the reports.
No story about China, no prediction about China’s
future gets more attention or more traction from
consultants, authors, experts, policy analysts. It
encapsulates the unanimous hopes of China's
leadership, and the fears of America's. “China is
now standing at a critical stage in that its economic
growth must be driven by innovation,” declared
China’s ruling State Council in May.
While China is making strides, the reality is
sobering. For all the hype, the government policies,
encouragment and cash, China remains a high-
tech disappointment, more dud than ascending
rocket. As an investment bank focused on China,
we very much wish it were otherwise. But, we see
little or no concrete evidence of a major change
underway. The best the many boosters can offer is,
“give it more time and it’s bound to happen”. In
other words, they make their case unfalsifiable, by
saying today's China's tech famine will turn into a
feast, if only we are prepared to stand by the
empty banquet table long enough.
CFC's chairman puts it like this, "unlike a lot of
those forecasting China's inevitable rise to a
technology superpower, I've actually met and
talked with hundreds of Chinese tech companies,
and before that run a California venture capital
firm with investments in the US, Israel and Europe.
I've also run as CEO a high-tech enterprise
software company in the US that used proprietary
technology to gain leading market position and
ultimately a high price from an acquirer when we
sold the business. So, I've been around the tech
world awhile both in China and elsewhere. Rule
number one: deal with the facts in front of you,
not wishful thinking. Rule number two: a high-tech
economy is not a quotient of national IQ, national
will, national urgency or national subsidies. If it
were, China might well by now be at the epicenter
of global innovation."

INSIDE THIS REPORT:
China’s High-Tech Ambitions & Disappointments 2
Taobao Is Killing Off China’s Shopping Malls 5
3M in China: a Success Story 7
How China Buried India 9
PE Partner Churn 11
Investors vs. Asset Managers 12
Unmanageable Beijing 14
China’s Farmland: Who Owns & Farms It 16
China Logistical Nightmare 17
The Big Four’s Big Headaches in China 19
Tiananmen 25 Years Later 20

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High-tech is meant to be a savior of China's
economy, delivering higher levels of affluence in
the future and an escape from the so-called
"middle income trap" that has slowed growth
elsewhere in Asia. But saviors have a habit of
never arriving. Let's investigate why China has up
to now made little progress in high-technology. But,
first, we want to highlight one core example of how
China has been unable, despite momentous efforts
across more than a decade, to reach even the first
rung of advanced high-tech competence: designing
and serially producing jet engines.
Military power both requires and underpins high-
tech success. Any doubt about this was eliminated
by the collapse of USSR. CFC's chairman was lucky
then to have a front-row seat for that event. He
spent years as a Forbes journalist visiting the
USSR, surveying both its military and civilian
industries, its indigenous technology base. He was
one of the few who got to spend time, for example,
inside the top-secret Soviet rocket program,
including visiting main factories where its rockets
and space station were built. The rocket program
was the pinnacle of Soviet tech achievement.
But, it proved to have little overall spinoff benefit
for USSR economy. It was a dead-end. Note: the
Soviet Union then, like China now, had far more
engineers and engineering graduates than the US.
US's military supremacy, then and now, rests as
much on Intel and Broadcom as it does on
Lockheed Martin fighter jets and GD nuclear
submarines. The US has a huge, fast-adopter
civilian technology market with strong competitive
dynamics, something China is without. This means
US military then and now can procure the best
chips, best integrated software and systems
cheaply and quickly from companies that are
mainly serving the civilian market. The Soviets had
no civilian high-tech industry, no market forces.
The Soviet military was exposed as a technology
pauper by the 1989 Iraq War.
China is different and better off in many ways. It
manufactures a lot of the world's most advanced
civilian high-tech electronics products. This gives
China huge advantages the USSR never had. All
the same, the USSR by the mid-1950s was
producing jet engines for military and civilian use.
To this day, China relies on Russia, using Soviet-
successor technologies, for its advanced jet
engines. Russian jet engines are generally
considered at least a generation behind the best
ones manufactured now in the US, France, UK.
It is puzzling to us, and certainly even more so to
China's military leadership, why China is still not
able to make its own advanced jet engines. The
reasons, as far as we can judge, also cast light on
problems China has, and likely will continue to
have, developing a globally-competitive indigenous
technology base. In the case of jet engines, the
problems are at the manufacturing level
(difficulty to serially produce minute-tolerance
machinery), the material level (lack of special
alloys) the industrial level (only one designated
monopoly aircraft engine producer in China, so no
competitive dynamic as in the US between GE and
P&W) for the design, monitoring and lifecycle
management of civilian and military jet engines.
A recent report on China's jet engine industry puts
the technology gap in stark terms. "In some
areas," it concludes, "Chinese engine makers are
roughly three decades behind their U.S. peers."
This challenge, to bring all the parts together in a
high-technology manufacturing project is also
evident in China's failure, up to now, to develop
and sell globally domestically-developed advanced
integrated circuits, pharmaceuticals, new materials.
In drug development, China by some estimates
has spent over $10 billion on pharmaceutical
research and up to now has had only one
domestically-developed drug accepted in the global
market, the anti-malarial treatment Qinghaosu
(artemisinin). Interestingly, it is derived from an
herbal medicine used for two thousand years in
China to treat malaria.
It's simply not enough to count engineers and
patents or the content of government technology-
promotion policies. China lacks many of the basic
building blocks of high-tech development. Included
here is a mature, experienced venture capital
industry staffed by professional entrepreneurs and

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technologists, not MBAs. A transparent judicial
system is also essential, not only for protecting IP,
but managing the contract process that allows
companies to put money at risk over long-periods
to achieve a return. Non-Disclosure and Non-
Compete agreements, a backbone of the
technology industry in the US, are basically
unenforceable in China. Anywhere this is the case
you can about wave goodbye big-time technology
innovation.
While ignoring the troubling lessons of China's
failure to produce a jet engine (as well as jet
brakes and advanced radar systems) the boosters
of China's bright tech future these days most often
cite two mobile phone-related businesses as proof
of rising innovation. The two are Xiaomi mobile
phones, and Tencent's WeChat service. Both have
had success in the last year, including getting
some traction in markets outside China. Look a
little deeper and there's less to be positive about.
Xiaomi is a handset manufacturer that now has a
market valuation of over $10 billion, higher than
just about any other mobile phone manufacturer.
It relies mainly on the same group of US
companies (Broadcom, Qualcomm, Google) for key
technology in its phones. They, along with UK chip-
maker ARM and Japanese screen manufacturers,
are the ones making the real money from Android
phones. In addition, Xiaomi's phones are
manufactured by Taiwanese company Foxconn. As
of now, China has no domestic company that can
achieve Foxconn's levels of quality at low
manufacturing cost. Foxconn does this from
factories in China. Its superior management
systems for high-volume high-quality production
also underscore another area where China's
domestic technology industry is weak.
With WeChat, it's done some impressive things in
signing up over 300 million users. The basic
application is similar to that of Facebook's
WhatsApp and others. It would be hard to suggest
Tencent has demonstrated technology leadership
in this area. Its real technology strength, though,
is in its back end, in building and managing the
servers to store all the content that is sent across
WeChat, including billions of video and audio files.
Whatsapp doesn't have similar capacity. In fact, it
points with pride to the fact it doesn't backup for
storage any Whatsapp customers' conversations.
Tencent does this because it's required to do so by
Chinese internet rules, and government's policies
to monitor internet content. Tencent might be able
to commercialize and sell globally its backend
storage architecture, but it's not clear anyone
would be interested to own it. It's a technology
that evolved from specific Chinese requirements,
not market demand.
Last month CFC's chairman spoke on a panel at a
conference for the global bio-manufacturing
industry. Bio-manufacturing is precisely the sort of
high-tech endeavor where China most needs to up
its game. Bio-manufacturing relies on a mix of
first-rate science, cutting-edge manufacturing
techniques and capable management. After all the
talk and the establishment of dozens of
government-funded high-tech science parks across
China, the simple verdict was China has yet to
achieve any real success in this industry.
China is not alone, of course, in having its
difficulties creating and nurturing a globally-
competitive indigenous technology industry. In
their time, most of the world's advanced major
economies have all tried -- Germany, France,
Japan, UK. All lavished government subsidies to
foster domestic innovation.
All made technology a policy priority. Yet, all have
basically failed. If anything, the US is now more
dominant in high-technology than it was at any
earlier time in history. The US is home to most of
the companies earning high margins, market
shares and license fees for their proprietary
technology.
China has already achieved what no other country
has: in the course of a single generation, it has
achieved the highest-ever sustained rate of growth,
and so lifted hundreds of millions of its citizens out
of poverty. This achievement shows the capability
of the Chinese people, the wisdom of its policy-
makers. Both will continue to deliver benefits for
China across generations to come.

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For China, becoming a tech power is neither
certain nor impossible. Progress can be hurt, more
than helped, by those who engage more in hype,
in predicting certain outcomes, rather than
critically assess the impediments, and learn
lessons from the failed efforts so many other
countries have had in developing a technology
industry.
New thinking about innovation, and how to
encourage it in China, is still lacking.
Alibaba’s Taobao and
Other Online Merchants
Are Pushing Traditional
Retailers in China
Towards Extinction
Welcome to the desolate future of mall retailing
in China.
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This seven-story skylit shopping mall occupies a
premier spot in a high-rent commercial district in
booming Shenzhen’s main shopping street, with a
huge underground parking lot and entrances that
link it directly with a busy Metro stop. And
yet, everywhere you walk, floor after floor, retail
shop fronts are boarded up, with most stores
closed down. Only the ground floor supermarket,
top floor Multiplex movie theater, basement chain
restaurants and a large Starbucks are thriving.
Thousands of square meters of retail space, fully
rented as recently as twelve months ago at some
of the highest commercial rents in the world, are
silent and vacant. No customers, no tenants, no
rent income.
Malls are starting to empty out in China, but
Chinese are richer, and spending like never before.
Overall, retail sales rose 13% in 2013. The
paradox can be explained by a single word:
Taobao. It is China’s largest online shopping
business, and the anchor asset of Alibaba Group,
now preparing for one of the world’s richest-ever
IPOs on the US stock market. Taobao, along with
its sister site TMall, and a host of smaller online
retailers including Jingdong, Amazon China and
Wal-Mart-controlled Yihaodian, have landed like an
asteroid, and are wiping out the ecosystem
supporting traditional retail in China, especially
brand-name clothing shops.
The impact of online shopping in China is already
far more wide-ranging than anything seen in the
US or elsewhere. The reason is price. Taobao and
others sell the same brand-name products
available in shopping malls, but at prices often
30%-50% cheaper. More even than rising incomes,
online shopping is the most powerful force in China
for raising ordinary Chinese living standards and
purchasing power.
Online shopping is everywhere in the world, at its
heart, a price discovery tool. And Chinese are now
discovering, in their hundreds of millions, they
have been getting seriously ripped off by
traditional stores, especially those selling foreign
and domestic brand-name clothing and consumer
electronics. They usually occupy 70% or more of a
mall’s retail floor space.
Alibaba and other online merchants are joyously
surfing a tidal wave of dissatisfaction with the high

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price of store shopping in China. Not only are
brick-and-mortar stores’ prices much higher than
buying online, they are also often more expensive,
in dollar-terms, than the same Made-in-China
products sold at Wal-Mart or Target in the US.
Those two giant chains have fought back against
online retailers in the US by using their buying
power to offer brand name products at low prices.
No retailer in China is really attempting this.
Retailing in China is both fragmented and
uncreative. As dynamic and innovative as China is
in many industries, we’ve yet to see even one
great home-grown retailing business here in China.
There’s also a big problem in the way Chinese
shopping malls, especially high-end ones, are
operated. Chinese mall owners are mainly a motley
assortment of one-off developers who used
government contacts to nab a valuable piece of
commercially-zoned downtown land at a fraction of
its market value. They then mortgaged the
property, built a fancy shopping palace, and now
take a cut of sales, along with a baseline rent. This
revenue-sharing discourages retailers from cutting
prices. If they do, they will fail to meet the
landlord’s minimum monthly turnover figure.
Compounding the pressure on traditional retailers,
mall owners often give the best ground-floor
locations to global brands like Louis Vuitton or
Prada, who pay little or no rent, but are meant to
give the mall a high-class ambiance. The big luxury
brands’ China outlets seem to have rather anemic
sales, but use their China stores as a form of brand
promotion richly subsidized by mall owners.
Domestic brands are shunted to higher floors.
Fewer shoppers venture up there, and so the
stores will often end up failing.
The result, as in the photo above taken on a recent
Sunday, floor after floor of vacant space. China is
creating an entire new retail landscape – a
glamorously-appointed mall in a nice part of town
whose upper floors resemble downtown Detroit
after a riot, with boarded-up shop fronts and
scarcely a soul.
Anywhere else in the world, a mall with so much
vacant space would either need to cut rents
drastically or hand the property over to the banks
that lent the money. Neither is happening. For now,
the banks can often afford to be patient. Malls that
have been around for a few years have probably
already paid off the loan principal. Newer loans
look far shakier. There are hundreds of bank-
financed high-end malls now under construction or
opening this year across China.
The stampede away from malls is only just
beginning. Though China has already overtaken
the US in dollar terms as largest online shopping
market, there is every sign that the shift to buying
online is accelerating and irreversible. Online sales
in China should reach 10% of total retail sales this
year, well above the US level of 6%. We project
this percentage will rise to over 15% within the
next decade. That’s because more Chinese will
shop online, especially using their mobile phones,
and because the range of items that are cheaper to
buy online is so much larger in China than
anywhere else.
For that, online merchants must also thank the
country’s parcel delivery businesses, led by
Shunfeng Express. They charge so little (about
one-tenth the price of Fedex or UPS) and are so
efficient in getting your parcel into your hands
quickly that it makes economic sense not only to
buy higher-priced apparel, office supplies, books
and consumer electronics, but also packaged food,
soap, personal care items, even knickknacks that
sell for less than $1.
The retail stores that remain in shopping malls are
increasingly being used as free showrooms to
facilitate sales by online competitors. Chinese
shoppers go to stores to find what they like, try it
on, check the price, then go home and buy direct
from Taobao. That’s one reason malls are still
drawing crowds.
Online shopping is not only cheaper, customer
service is usually much better. Most merchants
selling on Taobao manage and run their own online
shops. Taobao is nothing more than an
aggregation of millions of motivated individual

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entrepreneurs. They are available just about any
time, day or night, by phone or online chat to
answer questions, or even, when asked, offer an
additional discount. They are, in our experience,
smart, self-confident, friendly, competent.
Sales help in stores are often poorly-paid younger
women who cling together behind the cash register.
They clearly don’t much enjoy what they are doing,
nor are they there to enhance the shopping
experience. Often just the opposite.
So what’s going to happen to all the malls in China?
There are over 2,500 across the country, already
more than double the number of enclosed malls in
the US. More are opening around China every
week. Who will fill up all the space? There’s serious
money to be made by investors or operators who
can take advantage of the large disruptions now
underway in traditional retailing.
Restaurants in malls are still doing well, and they
don’t have anything to fear from Taobao. But, food
outlets generally pay lower rent, per square foot,
than retail stores and occupy either the top or
basement floors. Premium office space is also still
in demand in the downtown areas where many
malls are located.
Should malls be turned into food and
entertainment centers? Or converted to
commercial offices? Neither path looks easy.
The US went through a large wave of shopping
mall bankruptcies in the 1990s, as large operators
like DeBartolo and Campeau failed, and better
ones like Simon Property Group and Westfield
Group thrived. The good operators lowered costs,
improved the economics and did well as newer
retailers like Victoria’s Secret, Abercrombie & Fitch,
Hollister, Juicy Couture, H&M, Apple, Papyruys,
Teavana, Nordstrom honed retail formulas that
could withstand online competition.
Retailers in China are in such peril because they
charge too much, never innovate and do so little to
win the loyalty of their customers. Alibaba and
other online sellers are hastening their extinction.
3M in China: a
Magnificent Minnesota
Multinational
Through pain comes wisdom. US manufacturing
giant 3M has a superb business in China that by
sales, growth, product diversification, brand equity,
market share and margins must place it among the
very best, if not the best, US companies operating
here.
This overdue realization came courtesy of having a
nasty little cavity filled in China. As CFC’s chairman
squinted through the pain, he saw the dentist
reach for a small tube of 3M-branded epoxy to fill
up the hole in my tooth. “3M is American, like you,
right?” she asked in Chinese. “This is the best
product on the market.”
Modern dentistry didn’t really much exist in China
until around 20 years ago. Since then, the growth
has been hypersonic. Today there are about 60%
more dentists in China than in the US, 135,000
compared to 85,000. The number of dentists is
growing by 15,000 a year in China. 3M helped
build the dentistry market from the ground up, and
now enjoys a level of market penetration and trust
in China exceeding the US.
Dental products are just one among many dozens
of areas where 3M has built a large and profitable
business in China. Another one we know of:
reflective tape used on traffic signs and glow-in-
the-dark clothing worn by police and other first
responders. 3M enjoys something like a monopoly
here, during a time when no other country is
adding as many miles of roads, and as many bright
new road signs as China. We have a Chinese client
that tried, without much success, to compete with
3M in the market. Despite having better
government contacts and lower prices, this
Chinese company has gotten steam-rollered by 3M
in China.
In industrial adhesives, photovoltaic components
and, of course, Post-It Notes, the situation is the

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same. 3M has flattened every Chinese competitor
that came after it. 3M’s China strategy is as simple
as it is successful: premium products, prices and
market shares.
3M has been in China since 1984, almost as long
as the country has welcomed American investment.
Over that time quietly but oh-so efficiently it has
built a powerful business in China, with revenues
last year growing 16% to over $3 billion. China
sales are growing three times faster than overall
3M revenue. The company’s China CEO is on the
record predicting 3M’s revenues in China will
overtake its sales in the US ($9.5 billion in 2013)
within the next ten years.
That would be an impressive achievement. But, we
wouldn’t bet against 3M. It has as strong a
platform for growth in China as any company we
know of, domestic and international. It sells
hundreds of different products in over eighty
separate product categories in China. In a county
where no company’s intellectual property (patents
and know-how) is meant to be safe from pirates,
3M has defended its secrets, and stayed
comfortably ahead of local brand knock-offs and
copycats. Counterfeiting is a separate issue, and
probably 3M’s biggest problem in China.
In a way few, if any, other US multinationals have,
3M has managed to achieve significant sales and a
stellar reputation both in consumer and B2B
markets. As China grows richer, 3M’s strategy
looks smarter and smarter. Cheap, low-quality
products are being driven out of the market here.
Consumers, factories and government departments
are trading up.
This leaves many low-end Chinese brands in a very
difficult and life-threatening position. They can
only compete on price in a market that’s
increasingly price-insensitive. 3M is precisely the
kind of manufacturing company China itself most
sorely lacks – a serial innovator with branded
products that can command higher prices.
Most Chinese dentists and handymen still stock
lower-quality Chinese-made products. They offer
customers a choice – something one rarely runs
across living in the US of Europe. You want the
good imported stuff or a cheap knockoff? The price
difference can be rather high.
For cavity-filling compound, using 3M product will
cost you about three times as much. To fix a chair
leg using 3M glue it’s double the price. But,
dentists and handymen we asked say almost none
of their clients are opting for the local brands.
3M is admired just about everywhere for the
quality of its products. But, in China, it has an
almost saintly reputation. During the height of the
SARS epidemic in 2003, 3M disposable masks were
widely publicized in the Chinese media as the most
effective way to prevent the spread of the deadly
disease. Today, 3M disposable masks are widely
used by Chinese for another purpose, to block out
the serious pollution and fumes that envelop big
northern cities like Beijing, Jinan and Shanghai.
Other US companies with large China businesses
have hit on tough times lately in China. P&G and
Coca-Cola Company are losing market share to
local competitors. Yum! Brands and Mondelez have
both suffered from perceptions they peddle
unhealthy food. Their best days in China, from our
vantage point, are probably behind them.
3M, meanwhile, quietly and steadily goes from
strength to strength. If any US company can add
another $7 billion in revenue in China over next
decade, 3M is the most likely.
3M not only introduced its products to China, it
also transplanted its rather unique American
Midwestern personality. 3M China is, by local
standards, modest, elf-effacing, even dull. It
doesn’t advertise much, or throw its weight around
as one of the largest US companies operating here.
The Maplewood, Minnesota-based parent barely
even mentions China in its 2013 10-K annual
report.
When you are doing this well in the world’s
strongest-growing major market, adding billions in
revenues and beating up your competitors, why
tell the world about it?

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How China Buried India
Twenty years ago, India, not China, was the
object of the CFC chairman Peter Fuhrman's
focus. Back then, he was living in London and
working as a European bureau chief for Forbes
Magazine. In May 1994, a story he co-wrote called
“Now We Are Our Own Masters” appeared on the
cover of Forbes. It was the first time a big
American magazine took the risk to suggest India,
after so many years of pathetic growth, famine and
unending poverty, was ready for an economic
take-off. It turned out to be a pretty smart call.
Since then, India’s economy has surged, growing
seven-fold while poverty has declined steeply.
Peter tells the story like this: "I spent about a
month in India researching the article, meeting
with political and business leaders. It was my third
trip to the country. The first had been in 1978, as
a young backpacking college student, on my way
back to the US from a summer in Taiwan studying
Mandarin. The two most vivid memories of that
first trip — nearly dying from untreated amoebic
dysentery, and hiding out for days in a place called
Aurangabad as masses of Indian men rioted on the
streets against the forced sterilization policy of
India Gandhi.
"It took another three years before I first set foot
in China. On a lot of levels, the two countries
struck me as similar back then, both in the extent
of the obvious poverty as well as the shared
disappointment some thirty years after each had
gained full independence as socialist states under
charismatic intellectual leaders, Jawaharlal Nehru
in India and Mao Zedong in China.
"China began its reform process a decade earlier
than India. I caught the first stirrings when I
arrived in Nanjing as a student in 1981. When I
went to India in 1994 for the Forbes article, it still
seemed plausible India might one day emerge as
the larger, more vibrant of the two economies.
China had suffered a sharp setback in 1989, during
the Tiananmen Square Protests of 1989, an event I
witnessed first-hand in Beijing. At the same time,
India had begun to liberalize and energize its over-
regulated and inefficient state-run economy.
"While India’s growth has since surpassed my
optimistic hopes in 1994, I firmly believe it will
never rival China. This chart below shows how far
the gap between the two has grown. Since 1994,
China has all but left India behind in its tailpipe
exhaust.

India’s GDP Growth 1950-2010
India vs. China GDP Growth 1960-2010

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"In per capita PPP terms, China is now almost 2.5
times wealthier than India. Year by year, the gap
grows, as China’s gdp expands faster than India’s,
while India’s birth rate is now almost triple China’s.
"I haven’t been back to India since 1994. I have no
doubt it’s changed out of all recognition. Changed
for the better. Poverty is down. Exports are way up.
Its biggest misfortune may be having to compete
for capital, and for attention, with China.
"Living full-time and working in China now for
more than four years, I’m more impressed than
ever how superbly China is engineered for rising
prosperity. The comparisons I read between India
and China generally give a lot of weight to the
difference in political systems, between India’s
raucous federal democracy with dozens of parties
and China’s one-party centralized rule. The
indisputable conclusion: sound economic policies
are easier in China to design and execute.
"The few times I’ve been asked to contrast the two
countries, I prefer to focus on their most valuable
long-term assets. India has English. China has
Confucius.
"India doesn’t out-compete China in too many
industries. But, in two of these — pharmaceuticals
and computer software — English is probably the
main reason. India’s educated population is
basically native fluent in the language. China has
tried to make more of a game of it, especially in
computer software and services. But, China is now
and will likely remain a bit player in these two
large, global high-margin industries.
"India also has, overall, a more innovative financial
services industry. This isn’t really the result of
widespread English, but the fact that India has a
more open financial and currency system than
China’s.
"Both nations benefit from having large diasporas.
In India’s case, it’s a huge source of cash, with
remittances of over $65 billion a year, equal to 4%
of gdp. In China, the benefits are as much in kind
as in cash. Companies owned or managed by
ethnic Chinese from Southeast Asia, Hong Kong,
"Taiwan and the US have been large corporate
investors in China, with the capital matched by
transfer of technologies and manufacturing know-
how. This is an ever-renewing remittance, as
money pours in each year to finance projects with
solid long-term rates of return.
"China’s trump card, though, is its Confucian value
system. Its potency as an economic force is amply
demonstrated by the affluence of China’s
Confucian neighbors, not just Hong Kong,
Singapore and Taiwan, but South Korea and Japan.
Its impact is measurable as well in the outsized
economic clout of Chinese immigrants in Thailand,
Philippines, Indonesia. Free market capitalism and
Confucianism. Anywhere in the world you find
sustained economic success and rising prosperity,
you will find at least one. In China, they are
entwined in a kind of ideal synthesis.
"India, too, has close-knit families and a tradition
of thrift and obedience. Confucianism adds to
these a reverence for education and practical
problem-solving. It contains nothing transcendent,
not much, if any, spiritual guidance for soul-
searchers to make sense of their place in the
cosmos. Honor your ancestors with burnt offerings,
sweep their graves at least once-a-year and they’ll
grease the wheels of success in this life.
"The Confucian system hasn’t changed much for
two thousand years. One vital adaptation over the
last century, though, was to accept that women
could, and should, play an active role outside the
house, reaching the same educational level as men
and joining the workforce in equal numbers. Here,
India is woefully far behind. China’s growth has
been on steroids these past twenty years because
its 650 million women have contributed
exponentially more to economic growth and
prosperity than India’s.
”Of the couple hundred stories I wrote while at
Forbes, I’m probably proudest of this India cover
story published twenty years ago. It may not seem
like it now, but it was a gamble to suggest back
then under my byline India was about to come out
of its long economic coma. Imagine if instead I’d
gone on the record 20 years ago to forecast the

11
coming economic miracle in Russia, Mexico or
South Africa – all countries back then seen by
some to be “the next great emerging market”. I
heard afterward the article helped generate more
interest in India’s economic reforms and ultimately
more investment in India by US multinationals.
This grew about 30-fold in the ten years after the
article appeared.
"On a personal level, I made a larger, and I think
even safer bet with my own professional life, to
move to China and start a business here. Yes,
India has English. I work every day in an alien
tongue and in a culture steeped in Confucian
values that play little or no part in my own ethical
code. But, China was, is and shall long remain the
great economic success story of all-time. "
The Big Churn: High
Partner Turnover at PE
Firms in China
What’s the biggest risk in China private
equity investing? Depends who you’re asking. If
you ask LPs, the people who provide all the money
that PE firms live off, you will often hear a
surprising answer: turnover at PE firms. Nowhere
else in the PE and VC world do you find so many
firms where partners are feuding, quitting or being
thrown off the bus.
A partnership at a PE firm is meant to be a long-
term fiduciary commitment. In China, it rarely is.
The result is billions of dollars of LP money often
gets stranded, and possibly wasted. That’s because
when a partner leaves, it often creates a bunch of
orphaned investments. The departing partner is
generally the only solid link between the PE firm
and the investee company. Everyone left behind is
harmed — the PE firms, the companies they invest
in, and the LPs whose money is trapped inside
these deals.
As the CEO one of Asia’s largest and most
professional LPs explains it, “Before committing to
a new China fund, we spend more of our time
trying to figure out how the partners get along
than just about anything else. Will they hang on
together through the life of the fund? We know
from experience how damaging it is when partners
fall out, when key people leave. We know turnover
can mean we lose everything we’ve invested. And
yet, we still often get stung. ”
The PE and VC industry in the US and Europe has
far less churn. A quick look through our database
of PE contacts reveals that almost half the PE
partners we know working in China have changed
firms in the last five years.
One reason you don’t see this elsewhere is that
partners expect to earn carried interest on the
deals they’ve made. If they leave, they forgo this.
Carry is a kind of unvested pay. On paper, it’s
often quite sizable, and should represent the
majority of a PE partner’s total compensation, as
well a kind of golden handcuff. The only reason for
partners to leave is they believe they won’t get any
of this money, either because of failed deals or,
more commonly, large doubts that the head
partner, the person running the firm, will share the
rewards from successful deals.
Most China PE firms are partnerships in name only.
There is usually one top dog, usually the founder
and rainmaker. This person can unilaterally decide
who stays, who goes, who gets carry and who gets
a lump of coal. Top Dog tends to treat partners like
overpaid, somewhat undeserving hired hands.
So, why have partners at all? Often it’s because
LPs insist on it, that they want PE and VC firms in
China to be structured like those elsewhere. The
business card says “Partner” but the attitude,
expectations and level of commitment say
“Employee” with circulating resume.
Senior staff (Vice Presidents, Managing Directors)
also frequently depart. In the US, you don’t often
see that much, since these are the people in line to
become partners, which is meant to be the

12
crowning achievement of a long successful career
in the trenches. They leave because they don’t
believe they’ll be promoted, or if they are, that
they’ll see any real change in their current status
as wage-earners.
At a party celebrating a recent IPO of a PE-backed
Chinese company, we ran into the PE guy who led
the original investment, did all the heavy lifting. He
had since left and joined another firm. He laughed
when asked why he would leave before the IPO,
with his old firm certain to earn a big profit on his
deal. “I don’t know who will get the carry, but I
was sure it wouldn’t include me,” he explained.
Partners jump ship most often because someone is
offering a higher salary, a higher guaranteed
amount of pay. Their new firm will usually also
offer them carry. Both sides will negotiate fiercely
over the specific terms, what percent with what
hurdle rate. And yet, more often than not, it seems
to be a charade.
From day one, the new partners may already be
thinking about their next career move, how to
trade up. Emblematic of this: here in China, when
PE partners join a new firm, they almost always
refer to it as “joining a new platform”. Note the
choice of words: platform, not firm.
The LPs — and we speak to quite a lot of them —
acknowledge, of course, that there are other big
risks in China, that individual investments or even
a whole portfolio turns sour. But, this is a risk
inherent in all PE investing everywhere. High
partner turnover is not.
PE partners deserve to earn a good living, and
should work where they are happiest and best
compensated. But, China’s PE industry serves a
deeper economic purpose and holds in trust the
assets of both investors and companies.
More continuity at the top and less job-hopping is
a necessary step in the maturation process of
China’s PE industry -- and the maturation process
of the Chinese economy as well.
Investors vs. Asset
Managers: Which Path for
China PE?
Assuming the same level of risk, would you
rather make $100 from investing $10 or from
investing $50? Easy, right? Who wouldn’t choose
to make ten times your money, rather than just
double it? There is one group. Private equity firms
active in China. At least some of them. They care
more about the amount they can invest in a deal
than the profits they stand to make.
The illogic at work here is the direct result of some
particular, not very appealing characteristics, of
the PE industry in China. PE firms lately have more
confidence in their ability to raise money than to
invest it profitably by achieving a timely exit. To
raise money, though, a PE firm needs first to
spend most of what it already has. Result: a rush
to get money out the door and parked in deals.
In industry parlance, “check size” is often more
important than potential risk-adjusted returns. This
is one reason for the recent rash of take private
"P-to-P" deals of Chinese companies quoted in the
US. The transactions seem ill-considered. PEs have
invested billions of dollars in such deals but there
is not a single successful example they can point to
of such P-to-P deals done in the US making money
for investors. This must be a PE industry first — so
much LP money put at risk against an investment
idea that is totally unproved.
Who’s most harmed from focus on “check size”
over deal quality and prospective returns? Of
course it’s the LPs whose money is put into these
deals. They want and need high returns, not bigger
deals done using their money to aid PE firms’
future fund-raising.
But, Chinese entrepreneurs also suffer in this
environment, because many PE firms now simply
won’t look at deals where they can’t invest at least
$25mn for around 25% of the company. There are

13
few deals out there in that size range, meaning
deserving entrepreneurs can’t find investors.
The big picture here: PE in China has become more
and more a business dominated by asset managers
not investors. How to tell the two apart? An asset
manager enjoys the comfort and certainty of
making a steady 2% a year managing other
people’s money. The more money they raise, the
more money they keep. Good markets or bad, the
money keeps rolling in.
An investor, on the other hand, is a whole different
animal. They share some DNA with the
entrepreneurs they back. They love the sport of
finding and evaluating deals, spotting where big
money can be made, putting money at risk. When
it works, they make big sums for their investors,
and keep a nice chunk themselves.
Needless to say, LPs give money to PE firms in
hopes they have chosen investors not asset
managers. PE firms know this, of course, and tailor
their money-raising pitch accordingly. They stress
their deal-making prowess, not the fact that over
the life of a typical 10-year fund, an LP will start
with a 20% cumulative loss, because of the typical
annual management fee deductions.
In China, it used to be fairly easy to make money
in PE. But, over the last three years, returns began
to head south. More recently, over the last 18
months, the performance has mainly been dismal,
with few successful deals exiting with big profits.
It’s getting harder and harder for LPs to make
money in China PE, after those accumulated
management fees have been deducted.
But, there’s a time lag — as well as an information
asymmetry — at work here. While recent
performance has been, on the whole, lousy, there’s
still appetite among LPs to allocate more money to
China. A big reason is that China’s economy, and
capital markets, are both the second-biggest in the
world. Most LPs are seriously underweight China
and want to change that.
And so we arrive at the current paradoxical
situation, where it’s still comparatively easier to
collect money to invest in China than to make
money deploying it. Now, of course, PE firms can
only succeed in raising capital if they can point to
some successful past deals. Here too there’s an
information asymmetry at work. Many PE firms did
well from 2005-2010, and so their fund-raising
documents emphasize deals done during this era.
But, the game has changed out of all recognition
since then.
Few, if any, PE firms have shown they can
continue to earn investors good money when
markets become less accommodating. It’s no
longer possible to play the game of valuation
arbitrage, of investing in China deals at single digit
p/e multiples, and exiting them soon after at 5-10
times higher multiples through an IPO.
Earning a profit on an investment takes
preparation, luck and time. Making money by
convincing people to pay you a fee to manage
theirs, by contrast, is a much simpler proposition,
as well as a no-lose one.
And so the gulf widens between the objectives of
PE firms and the fiduciary responsibilities and
performance goals of the institutions whose money
they manage.
This can be a problem everywhere in the PE and
VC industry, as well as more broadly wherever
people get paid to manage assets owned by
someone else. Economists call this the “Principal-
agent dilemma”. It is especially pernicious in
China PE.
The industry is staffed mainly be ex-investment
bankers, who by background and temperament
understand more about fee-based, than
performance-based, compensation. Few have a
background of actually managing a company,
investing its capital to produce a return. Without
this first-hand understanding, it’s far harder as an
investor to plot how to make an operating business
more valuable. The result: PE firms in China will
often opt for an easier path: making money by
raising money from, and managing for, other
financial professionals.

14
How Beijing Became
Unmanageable: Blowout
Government Spending
Played a Big Role
What if most of what we think about
government spending was wrong? What if
government money causes, rather than
cures, pollution, unaffordable and substandard
housing, impossible traffic, more expensive and
less available healthcare? Sounds impossible, right?
Not if you live in or have traveled to Beijing lately.
The city’s now-infamous and perhaps incurable
urban problems are, at least in part, the result of a
deluge of government spending since the onset of
the financial crisis in 2008. Direct central
government outlays doubled to over Rmb 14
trillion ($2.2 trillion) over that time. Almost as
much, Rmb 13 trillion ($2.1 trillion), was borrowed
by local governments to finance their spending.
The government money, of course, wasn’t meant
to turn Beijing into an unmanageable urban sprawl
with a population larger than every state in the US
except California. In fact, most of the government
stimulus was targeted for big projects outside the
capital. But, in China, the nature of things is that
much of government spending travels on a round-
trip ticket. It is dispensed in Beijing and then a big
part of it eventually returns home. And no, this
isn’t all in kickbacks. A large part is from the build
out of a new huge new infrastructure in Beijing to
support, steer and encourage the distribution of
more government cash.
In the last five years, it seems like everyone
rushed to open or expand offices in Beijing, to get
closer to the action: companies of all sizes from all
part of China and the world; governments from the
smallest local hamlet 3,000 kilometers away to
provinces with populations larger than every
country in Western Europe also staffed up. Result:
commercial and residential real estate prices
skyrocketed to the point now where they are
among the highest anywhere in the world.
More people begets more cars, more cars begets
more traffic, more traffic begets restrictions on the
days-per-week any car can be on the road, which
in turn begets Beijingers buying an extra car to get
around the prohibition. End result: Beijing pollution
is now substantially caused by auto emissions, not
as in the old days by nearby-factories burning coal.
Many polluting factories have been shut down,
which added to the available land for development
into commercial and residential property in and
around Beijing, particularly in areas you need a car
to get to.
Here are the two charts, showing residential real
estate prices and cars registered in Beijing from
2008 through last year. It's common knowledge
the numbers are underestimated, by quite a bit.
But, they show the trend.
The torrent of government cash had all kinds of
spillover effects that have altered Beijing
permanently. More restaurants, higher prices,
more wining and dining, leading to prohibitions last
year, as part of the big "anti-corruption" crusade,
on government officials accepting invitations to
party outside the office. This then drives the
behavior underground, so high-end restaurants
empty out, while more expensive and exclusive
“members only” clubs in Beijing flourish.
Beijing has morphed from the political capital into
the cash capital of China. That’s attracted a large
group of players to move from Shanghai and Hong
Kong to get a piece. PE funds, private bankers,
lawyers, consultants, so-called “guanxi merchants”
who arrange access to government officials.
Among our friends in PE industry, we can count 15
who have moved to Beijing in recent years, to get

Vehicles Registered Residential Real Estate

15
closer to the action, and only one who left, who
finally couldn’t take the crowds, pollution, high cost.
The precise population is unknown. The official
number if 21.1 million. Some in government say
25 million. Others claim it could be closer to 30
million, if you count more recent migrants living
rough, plus the huge throngs in Beijing for shorter
periods, either for work or pleasure.
Since 2008, far more of China’s total economic
activity is decided by government bureaucrats in
Beijing. Overall government spending has more
than doubled. Result, more people need to travel
to Beijing more often.
Look at passenger numbers at Beijing’s Capital
Airport. Between 2008 and 2013, this already
crowded-facility saw passenger numbers increase
by a remarkable 50%. It is, as of March this year,
now the busiest airport in the world, eclipsing
Atlanta’s Hartsfield. Capital Airport is now breaking
under the load, and so Beijing is about to embark
on building an even larger new airport. This
mammoth $11 billion project by itself could
support a lot of Beijing’s gdp growth in the coming
few years. But, it will be just the cherry on top.
Beijing has the best hospitals in China, so people
come from all over the country to try to get
admitted for medical treatment. This has led to
price increases and longer waiting times. Equally,
those with a serious grievance about their local
government, or who feel maltreated, will often
gather up their documents go to Beijing to try to
get redress.
This trek to Beijing has been around since the days
of the Emperors. As China’s government grows in
power and economic clout and ordinary Chinese
have the money to fight back those seeking to
petition central government's help increase.
To serve all the new arrivals and visitors, Beijing
continues to expand its Metro system. The average
daily ridership is now 10 million, about triple
London’s, and also triple the amount five years ago
in Beijing. Waits at rush hour to get into some
stations can be horrific so the government recently
proposed to raise fares. Beijing currently has the
cheapest public transportation of any big city in
China.
Likely result of raising commuting costs: some
may leave Beijing, but more may seek to buy a
new car. They will join the lottery waiting for
permission to buy one. Yes, you need to win a
lottery for the right to pay twice the price of the
same car sold in the US, and can only legally drive
it on Beijing's roads every other day. By last
September, there were 1.6mn people in the Beijing
car lottery waiting for their number to come up.
How bad is traffic in Beijing. Horror stories abound.
A more reasonable evaluation: the manager of a
big telecommunications company we know says if
he doesn’t leave his house by 7am, it will take 90
minutes to drive 10 km from his house to his office.
That’s about speed of sedan chairs used to carry
emperor and his cohorts inside the Forbidden City.
To be sure, Beijing is not Dhaka. Since 2008, many
aspects of the city’s infrastructure have been
upgraded. It is a thoroughly modern city, with
scarcely a trace of either poverty or blight. Thirty
years ago, Bactrian camels were still occasionally
seen on the streets hauling cargo.
For first time since 1949, the leader of the country,
Xi Jinping, is Beijing born and bred. Since he was a
boy, Beijing’s population has about quadrupled,
while China overall has almost exactly
doubled. Will he try to shift gears, slow or even
reverse the growth in the city's population? It
won't be easy. Government "stimulus" spending,
once turned on is notoriously hard to scale back in
any serious way. Do so and overall GDP growth will
likely suffer.
In its 3,000 years as China's major urban outpost
on the country's northern perimeter, Beijing has
experienced countless invasions, barbarian pillages,
conquests, uprisings. But, nothing in history has
altered Beijing as deeply, and perhaps
permanently, as five years of bounce-back and
kick-back from $3 trillion in government pump-
priming.

16
Who Owns & Farms
China’s Land Remain
Central Questions of
China’s 5,000 Year-Old
Civilization
When Deng Xiaoping assumed power 36
years ago, 80% of China’s population was rural,
mainly small-scale peasant farmers. Today, half
the 1.3 billion population is off the farm, living in
cities. Two obvious results: China is over twenty
times richer per capita in dollar terms. And, from a
country with a handful of major cities three
decades ago, China now has 160 cities with a
population of at least one million.
The Chinese government’s plan is for another 150
million Chinese to go from farm to city in the next
decade. But even then, there would still be as
many as 300mn too many people living in rural
villages. China, according to estimates we've
read, could be efficiently farmed by as few as
100mn full-time farmers, or 7% of the total
population. In the US, less than 2% of the
population works on farms. They live well. A
farming family in the US now earns on average
$108,000, 53% above the national household
average.
In China, peasants earn on average one-third as
much as urban Chinese. As peasant numbers
decline, the incomes rise of those remaining. A
depopulating countryside, however, won’t directly
solve rural China’s age-old problem: farm plots are
too small and often on uneven terrain. This limits
the use of farm machinery and modern farming
methods. Farm yields remain stubbornly below US
and European levels. This, in turn, means food
imports must rise inexorably. Year by year, China
moves farther away from an often-expressed goal
to increase its food self-sufficiency.
The solutions aren’t hard to formulate. China needs
fewer and bigger farms with more leveled ground
to permit efficient mechanization. But, achieving
this remains, for now, all but impossible. Part of
the problem is that all rural land in China is owned
by the state, so there’s no way for peasants to buy
land from one another. A larger problem is the
adverse impact this would likely have on Chinese
society.
China’s describes itself, even today, as a 农业大国,
“nongye daguo“, or “agricultural great power”.
This is in some sense an artifact of history. But, it
also reflects a deeper reality, that most Chinese,
even the most thoroughly urban, still have some
concrete connection to village China. Often this is
through extended family members still engaged in
peasant farming.
More directly, many people living in cities — if not
the majority than close to it — still hold rural
“hukou” and so generally have an entitlement to
farm a plot of land in their ancestral village. This
hukou system, though much criticized for depriving
many city-dwelling Chinese of full rights to low-
cost healthcare and schooling, acts as an almost-
universal national insurance plan.
Those now long-removed from farming life still
have the comfort of knowing if things ever got
really tough, if they lost their jobs or the small
business they started goes bust, they could go
back to where they or their parents came from.
They always have a place to live and enough land
to feed themselves and scratch out a bare living.
China is the most entrepreneurial place in the
world, which creates huge benefits for everyone
living here, including better products, services and
fast-growing incomes. Small farm plots widely held
is one reason for this. They act as the safety net.
So, creating a more efficient farming system by
giving peasants the right to sell or mortgage the
land they farm or hold title to might ultimately do
more economic harm than good. Chinese
government has so far stalled on major reforms of
peasant land ownership. Instead, city-dwellers are
renting the rights to farm their rural plots to local
peasants who have the energy and ability to
manage larger holdings. The incremental effect is
that average farm size will grow gradually. But, of
course, renting land isn’t the same as owning it.

17
No one will invest in improving the quality of the
land if they are renting it year-by-year. It’s not
only efficiency that suffers. The levels of heavy
metal soil contamination is reaching alarming
levels in many areas, especially Hunan Province,
source of 13% of the rice grown in China. Who will
pay to clean up the soil and so improve food safety
in China is a national problem without an obvious
answer.
The price of fruits, vegetables and grains are all
rising in China, lifting peasant incomes. But, so are
cash salaries for low-skilled jobs in cities. Run the
numbers and it still looks to be wiser in many
cases to leave the land. The standard land
measurement in China is the “mu”, equal to one-
sixth of an acre or about one-twentieth of a
hectare. The income from farming one mu in China
is about equal now to one week of low-pay wages,
for example, the salary for sweeping up factory
floors. Not many peasants own and farm 50 mu.
Travel through rural areas on China's high-speed
rail network and it takes less than a second for the
train to pass a typical small plot of farmed land.
There is rarely anyone one out in the fields.
Thanks to pesticides and chemical fertilizers, far
fewer people are needed to grow food. Every day
people leave the land and will continue to for
decades to come. But, who should own China’s
land and who should farm it remain the central
questions of China’s five-thousand year-old
civilization.
China's logistical
nightmare
China may be modeling itself after the wrong
part of the American economy. The money, the
rhetoric and the policies are all focused on trying
to replicate America’s lead in high-technology and
innovation. Instead, China would be long-term
much better off and its citizens enjoy immediate
higher living standards if it copied something far
more mundane from the US, its distribution and
logistics. If China’s $9 trillion economy has an
Achilles Heel, this is it. It simply costs too much to
get things into consumers’ hands.
Wholesale layer is piled onto wholesale layer, with
margin and fees extracted at every step. Fixers,
expediters, overlookers all take a cut. Trucks are
too small, tolls too high, warehouses too small,
and road traffic too congested in major cities.
Commercial and retail rents are high, relative to
per capita income level. In China, there is enough
“friction” in every retail transaction to start a
bonfire.
Logistical costs and bottlenecks are the single
biggest reason why so many goods made in China
are sold at higher prices than in the US. This has
more real-world consequences for average Chinese
consumers than the level of the dollar-Renminbi
exchange rate. It is logistics costs, all the
stickiness and expense of getting products to
market, that is most to blame for holding back the
buying power, and so spending impulses, of
Chinese consumers. Middlemen live well in China.
Consumers less so.
It is cheaper, in many cases, to get a product
made in China onto a container ship in Shanghai,
offload it in Long Beach, truck it across the US,
and then stock it on a shelf at a Wal-Mart in
Georgia then it is to put the same product in front
of Chinese consumers in a Wal-Mart in China. High
taxes don’t help. China’s VAT, applied to most
things sold at retail, is set at a higher level than
most sales taxes in the US. Another factor: retail
competition as Americans know it is also largely
absent in China. Stores don’t compete much on
price in China. Wal-Mart won’t say, but it’s a fair
assumption its margins in China are at least double
those in the US.
But, high consumer prices in China are mainly the
product of the high handling charges. A simple
example: fruit prices. Most fruit grown in China
costs as much or more in supermarkets here than
the same fruit grown and sold in the US.

18
Apples sell for around Rmb 6 (95 cents) per pound
and up in China. The apple farmer gets around
Rmb 1 per pound. The rest is liberally spread
among all those standing between apple tree and
one's mouth.
Adjusted for purchasing power, Chinese average
income levels are around 1/6th the US’s. So, that
Chinese apple sells for equivalent, in US terms, of
$6 a pound. That amounts to a lot of money per
apple being shared by people other than the
grower and the eater. How much? Chinese eat a
lot of apples. In fact, almost half of all apples
grown in the world are eaten in China, ten times
more than total US consumption.
We met the boss of one of China’s largest apple
shipping and packaging companies. Outside of
China, this is a razor-thin margin business. But,
the Chinese apple packer and shipper has net
profit margins well above 10%.
One of the most expensive links in the Chinese
domestic supply chain are road tolls. China’s are
among the most costly, per kilometer traveled,
anywhere in the world. Trucks carrying agricultural
products don’t pay tolls. Anything else moving
along China’s highway system pays full freight.
Depending where you are in the country, tolls run
as high as 25 cents a mile for passenger cars.
Trucks pay triple that. It all, of course, ends up
being passed along to consumers.
To amortize the tolls, truckers overload their
vehicles. This burns more fuel, degrades roadways
(justifying still higher tolls), and makes loading and
unloading more time-consuming and so more
costly. According to the boss of a large long-
distance shipping company in China's Northwest,
his trucks are routinely pulled over by traffic police
and made to pay various on-the-spot fines. This
can double the amount paid in tolls.
Everything about the logistics industry in China
acts as a sponge soaking up consumers’ cash. The
one exception: Shunfeng Express (顺丰快递). Little
known outside China, Shunfeng Express is China’s
most successful private shipping and delivery
companies. It alone proves that logistics in China
doesn’t need to be wasteful, expensive and
inefficient.
Shunfeng is modeled after Fedex, DHL and UPS,
but operates on a scale, and at prices, that would
be unimaginable to these global giants. Shunfeng
is a secretive outfit. Not much is publicly disclosed.
The founder lives in Hong Kong, but comes
originally from the mainland. It was started in
1993, and according to some media reports, its net
income in 2010 of Rmb 13 billion ($2.1 billion).
That may be a stretch, but Shunfeng is doing a lot
right and deserves whatever profit it keeps.
Shunfeng picks up and delivers documents,
packages and some bulk freight between cities in
China. It charges a fraction of what Fedex or UPS
do in the US. These US companies are mainly
prohibited to operate in China’s domestic delivery
market. It's doubtful they’d be so eager to enter.
For next-day document delivery within a city,
Shunfeng charges under $2. Delivery to other
cities: $3. If you want to move a few kilos of
freight, Shunfeng not only ship it, but will come
and package it for you. That part is free. The
shipping usually works out to less than $5 a kilo.
One of the main reasons Alibaba’s Taobao has
become so successful in China is that Shunfeng
ships Taobao purchases cheaply and efficiently
across China. Taobao, which operates like a cross
between Amazon Marketplace and eBay, will likely
facilitate transactions worth around USD$100
billion this year. A lot of that will get shipped and
delivered by Shunfeng.
They have an army of delivery guys. Most larger
office buildings in major cities have one
permanently stationed inside. You call for a pickup
and the Shunfeng guy arrives within minutes. Most
letters and packages get moved around by either
electric motorcycle or jet. It leases its own aircraft
to fly stuff around within China.
Shunfeng doesn’t do cross-country trucking. This is
one big reason Shunfeng are so efficient and so
cheap. Anything that moves by truck in China is
going to have multiple hands in the till, and so end
up costing consumers too much.

19
Shunfeng has achieved its massive scale and now
well-known brand in China without raising capital
from the stock market. They brought in a first
round of outside capital last year. There are few
private companies in China we admire more, and
who are doing more to benefit the average
consumer in China. For the good of every
consumer in China, Shunfeng should continue to
grow, continue to expand the range of what it
handles in China. That will do a lot to unstick
China’s logistical logjam.
The Big Four’s Big
Headache in China
Earlier this year, an SEC judge in the US
delivered a spanking to the Big Four accounting
firms, (PWC, E&Y, KPMG, Deloitte) barring their
Chinese affiliates for six months from doing audit
work for US-quoted Chinese companies. “To the
extent [the Big Four] found themselves between a
rock and a hard place,” the judge’s decision
declares, “it is because they wanted to be there. A
good faith effort to obey the law means a good
faith effort to obey all law, not just the law that
one wishes to follow.”
Overall, the judge’s 112-page ruling on the audit
work of the Big Four in China makes for interesting,
and at times damning, reading. The judge’s
decision should probably be required reading for
anyone working in China or investing in Chinese
companies. Investments in Chinese companies
worth many tens of billions of dollars rely, at least
to some extent, on the accuracy and reliability of
Big Four audits. That audit bedrock looks shakier
now than it did before the SEC decision.
The Big Four are appealing the judge’s verdict
meaning that for now at least, they can continue to
serve their US-listed Chinese clients, continue to
audit their accounts, and continue to earn sizable
fees for doing so. If they lose the appeal, they will
need to suspend for six months their main activity
in China. The Big Four have a near-monopoly on
audit work for the over 160 Chinese companies
listed in the US. Will their Chinese clients
permanently go elsewhere? What about the 15,000
people working for the Big Four in China? How will
the firms pay them during the half-year suspension?
How will they spend their working days if not
engaged in audit work?
This much is clear: whatever happens with the
appeal, the reputation and trustworthiness of the
Big Four’s work in China has taken a serious
beating. The judge’s decision is particularly ill-
timed. Chinese companies have only just regained
some of the lost trust of US investors, allowing
IPOs to resume.
This dispute between the SEC and the Big Four has
been bubbling away for over two years. It was
triggered by a series of SEC investigations into
serious misbehavior by some Chinese companies
then-quoted in the US — fraudulent financial
accounts, incomplete disclosure, faked revenues.
The companies were punished, and their shares
delisted from the US stock exchange.
But, what about the Big Four auditors? Why hadn’t
they uncovered and reported their clients’
misconduct to the SEC? Were the Big Four in China
careless? Negligent? Or even complicit in these
Chinese companies’ attempts to mislead US
investors?
This quickly became a focus of the SEC
investigation. To determine if the Big Four audits
were performed thoroughly and in compliance with
US securities laws the SEC asked the Big Four in
China for their audit papers — that is, the
complete written documentation showing what
they did and with what level of diligence and
accuracy. The Big Four refused the SEC requests to
hand over the audit papers, saying that to do so
would violate Chinese state secrecy laws.
They used the same argument with the judge. He
rejected it outright. Instead, he says the Big Four
demonstrated “gall” in “flouting” the SEC, were
“oblivious” to some core legal issues, and took a

20
“calculated risk” they wouldn’t get punished.
Strong stuff.
While the judge doesn’t say directly that greed was
a major factor in the Big Four’s decision to disobey
SEC orders, it may be fair to make that inference.
Their strategy seems basically having one’s cake
and eating it too. They wanted to keep earning big
fees for China audit work, while not fully complying
with US securities laws. In specific cases cited by
the judge, accounting fraud at US-listed Chinese
companies was first brought to light by short-
sellers, rather than by the Big Four audits.
The judge’s ruling notes the fact that over the last
decade, the Big Four have built very large
businesses in China. KPMG China and Ernst &
Young China both tripled in size from 2004-2012.
PWC grew fastest, increasing its staff four-fold to
over 8,000 people. Such rapid growth is
unprecedented in the recent history of large global
accounting firms.
One large irony here is that the Big Four are
accused by the judge of violating Sarbanes-Oxley.
That law has overall been very good to the Big
Four, since it gave accountants increased
responsibility to police US-listed companies’
financial accounts. The scope of audits increased
and with it the fees. But, when things go wrong, as
they have with quite a number of Chinese quoted
companies listed in the US, the auditors can
potentially be held legally liable.
The Big Four all argued to the judge they should
be treated leniently because if banned, no other
accountants in China have the training and
professionalism to do audit work that meets SEC
standards for investor protection. Any Chinese
company that can’t find a new auditor would need
to delist from the US stock exchanges.
The judge dismissed this argument, and helpfully
lists a group of five other accounting firms that
have done audits in China and, unlike the Big Four,
turned over audit papers to the SEC when asked.
Among those named: Grant Thornton, Patrizio &
Zhao.
Some big US multinationals including P&G,
Amazon.com, Apple, The Coca-Cola Company and
Nike, with large revenues and operations in China,
would probably also need to find new Chinese
auditors if the ban is upheld. Investing or
operating a US-owned business in China, never
easy, will become even trickier if the Big Four are
forced to down pencils in China and serve the six-
month SEC suspension.
Tiananmen 25 Years
Later: "I was There and I
Was Wrong"
By Peter Fuhrman, Chairman, China First Capital
Twenty-five years ago on the evening on
June 3, 1989, I was standing in the northeast
corner of Tiananmen Square as Chinese soldiers
emerged in large numbers from inside the National
History Museum a short distance away. From
loudspeakers came instructions that all those
gathered in the square should leave in an orderly
way. The Tiananmen Square Protest, begun seven
weeks earlier, was entering its final and most
brutal phase.
It would be another seven hours or so on the
morning of June 4th before the last of the
demonstrators would be led unharmed out of the
Square. The violence that night occurred elsewhere.
Chinese troops entering the city by road
encountered stiff resistance, particularly to the
west and south of the square.
I witnessed some of this at close quarters – the
mayhem and loss of life. I was a reporter at the
time. I don’t reflect often on these events, and this
is also the first time I’ve written about what I saw
there.
Most of what I and so many others thought was
true and inevitable at that time turned out to be
wrong. There was no civil war, no fracturing of the

21
country, no return to Maoism, no retreat into bitter
isolation, no dying of the universal hope here for a
better life.
China today is an infinitely better, fairer, richer,
more open and freer place than it was in 1989.
This is the reality that too many in the West are
unable or unwilling to see. Their views about China
were cast in concrete that awful night in June 1989.
All they often choose to see are ghosts of
repression and despotism.
So what I have learned these twenty-five
years? China’s long history, for all its stunning
achievements and millennia of global weight and
prestige, is also etched with pain — from war,
famine, civil discord. No single cataclysm could
possibly define its destiny or determine the
country’s future. Not Tiananmen. Not the Cultural
Revolution. Not the civil war that brought the
Communists to power in 1949. Not the Japanese
conquest of the 1930s, nor the Taiping Rebellion
eighty years earlier in which perhaps 30 million
Chinese perished.
“Amnesia” is what some Western commentators
and authors now choose to call it. I prefer to think
of it as a deep, practical and praiseworthy
resiliency. China is where it is today, at a moment
of prosperity and bright prospects unprecedented
in its history, because most, if not all, of the
country of 1.3 billion willed it there. Through toil.
Through self-reliance and self-improvement.
Through an unshifting focus on bettering their own
lives, and those of their families. And, also through
knowing when and how to bury the past.
Was this made easier because no news about the
Tiananmen protests circulates in official media, and
nothing is taught in schools? Quite likely. But, by
itself, the impact of this was negligible on China’s
transformation since 1989. The country is now
thirteen times larger, in per capita gdp terms, than
it was then. The improvement in people’s lives
goes beyond the scale of numerical measurement.
It is the largest, most complete and most rapid
uplift in human history.
Yes, some problems from 1989 still remain. China
has polluted air and water, as it did in 1989. It has
corrupt officials. As it did in 1989. Its politics are
now and were then opaque and closed in most
parts to public scrutiny. Then, as now, China
confounds and sometimes infuriates those who
visit it, study it, admire it, or seek to trade with it.
I left Beijing on June 15th
1989, together with my
oldest and closest friend, who was expelled as an
Associated Press journalist “due to alleged links
with student ringleaders”. We met as two of a
handful of American students in Nanjing in 1981,
when food was still rationed and China was as poor,
per capita, as India and poorer than just about
everywhere in Africa.
I stayed away for many years, moving back almost
five years ago. That friend is also back now in
China, raising his three children in Beijing. He and
I don’t see eye to eye on China. Our
interpretations are quite different on what
happened in Tiananmen that night, and the impact
it exerts over today’s China. We speak about it
rarely.
He’s writing a history book now on the many ties
that bind the US and China together. He is more
fixated on politics, with intrigues and policy shifts
in Beijing. I care little about that, and far more
about what happens here financially and
economically. We both feel grateful to live in China
now, and in our own ways, grateful also to hold
onto a few memories of China as it was 33 years
ago, and also on that night in 1989. No amnesia.
Some late middle-aged forgetfulness for sure.
China is not at all like the sad place we expected it
to become when we left Beijing together in 1989.
It is our home. It provides us both with
opportunity, friendship, purpose, careers,
happiness, love, occasional frustrations and, when
we remember to take note, a sense of
astonishment at all we’ve witnessed, and how
much farther China has come than we ever dared
imagine.

22

© CHINA FIRST CAPITAL
Global Outlook, China-focused investment banking for companies, financial sponsors
Tel: 0755 86590540 Email: ceo@chinafirstcapital.com Website: www.chinafirstcapital.com

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