“Why abroad?” you say. Well, as anyone who has ever worked in the private sector can attest to, private companies the world over always seek to make their taxable income as low as possible. It matters not whether the company is from the USA, China, or the European Union. Taxes are nothing more than an expense companies are burdened with and the less one has to pay, the better the company’s chances of survival and profit.
While true for public companies the world over as well, it is much more difficult for public companies to “under-report” taxable income than private companies… and it is in this disparity, that the great opportunity for reward exists with Private Equity abroad.
China, for example, is still a developing country, but is likely to form an integral component to our global economic growth engine for decades to come. Unfortunately for Chinese entrepreneurs (and fortunate for private equity investors), China also has very high unfavorable corporate tax rate. As a result, China’s private companies are estimated to “under-report” their profits anywhere from 40 to 100% on average. This creates a huge arbitrage opportunity for any private equity firm seeking to buy a Chinese company and take the company “public”… and China is not alone.
In short, to continue with the example, private Chinese companies are holding their multiples (value) below market in an effort to reap the rewards of avoiding the payment of taxes on all their profits. Private Equity Firms and Investors therefore are able to scoop up such companies at great value (lower multiples), merely bring their accounting in line with “public” reporting guidelines over the course of a two to three year period in preparation for an IPO, and then sell the company at a substantially elevated multiple based off their extreme growth and “success” over their short ownership period… even though, in reality all they have done is report more and more of the already existing earnings of the company to the public. Utilizing this methodology, it’s not unreasonable for a PE firm to realize returns of 300% or more with each such acquisition over a two to three year period. Do not the rewards seem to greatly override the risks? …I for one am thinking of learning some Mandarin.
By, Neil Palmquist CMAA, CEPA
October 26, 2009