Deep Green Coal

The coming of age of an old concept has huge potential for China’s coal sector.

I may wear an investment professional’s suit on the outside, but I’m a true techie on the inside. As a former software entrepreneur, I must admit that investing in core Chinese industrials—manufacturing, energy, food processing—leaves a certain part of my soul wanting. Don’t get me wrong; crisscrossing the Middle Kingdom in search of solid growth companies is plenty exciting, what with all the colorful characters and cultural nuances that come into play when doing business in China. But rarely do I get involved with a new idea that evokes the effervescent inspiration that drives technology entrepreneurs. That was, however, until I was introduced to underground coal gasification (UCG).

The name sounds more industrial than high-tech and it’s hard to imagine anything related to the coal industry that would inspire a technology entrepreneur, but UCG is a truly compelling concept striving to come of age. And nowhere is its potential bigger than in China.

Most of you—save those who are coal mining history buffs—are probably wondering: What in the h___ is UCG? Quite simply, it’s the process of burning coal directly in the ground and extracting methane (and other gasses) as a source of fuel. The method is relatively straight-forward. Two holes are drilled into a seam of underground coal using equipment that is nearly identical to that used for oil drilling. In one hole a drill-string with a burner at the tip and an oxidant are inserted. The other hole serves as a vent to extract the “syngas” (which in most cases is mostly methane) that is produced from the combustion process. Simple enough, but the potential benefits run deep.

Traditional coal mining becomes prohibitively expensive and very dangerous at depths greater than a few hundred meters, leaving nearly 85% if of the world’s known coal resources inaccessible. UCG on the other hand can be conducted at depths of 1000 meters or more. This alone has potential to increase recoverable reserves by as much as 400% according to a recent study by Lawrence Livermore Laboratories. Moving coal resources into mine-able reserves will immediately increase the balance sheets of coal companies around the world.

Another benefit is the cost. Simply put, it’s much cheaper to burn the coal in the ground than to dig it out, wash it, and ship it someplace else to be burned. In fact, the current cost is about US $2.00 per thousand cubic feet of methane gas, which is about 50% the cost for an equivalent amount of natural gas. Another way to look at it: coal that is consumed via UCG will produce about 85% the caloric value had it been consumed with traditional mining, but at a fraction of the cost.

And then there’s the environment. The CO2 that is produced during the UCG process can be easily captured and sequestered back in the ground, or sold for other industrial uses. Additionally, there is no coal dust or ash floating around the neighborhood, and the UCG footprint is far smaller than an open-pit or underground coal mine. Hard as it is to believe, UCG is a “green” technology.

The concept sounds so simple that you may be wondering why it hasn’t come to light earlier? Well, it has. The basic concept for UCG was conceived more than 100 years ago, and was pioneered by the Russians during the 1930s, and later by the US in the 1970s. But only now is the combination of advanced directional drilling technology, efficient burners, and economics conspiring to make UCG economically and practically beneficial.

And nowhere is the potential for its benefits greater than in China. China consumes 35% of the world’s coal and relies on coal for 70% of electric energy. Furthermore, much of China’s coal resources lie deep in the ground, and Chinese mines are among the most deadly in the world. And with the Chinese government under extreme pressure—both internally and externally—to find greener solutions to its growing energy problem, UCG has found heavy support from the Chinese government and industry alike. China now has the largest UCG development program in the world.

From an investor’s perspective, UCG and the early players that bring the technology to the Chinese market have enormous potential. Regulations make it difficult for foreign investors to own stakes in coal mines, but foreign UCG providers like the UK’s Clean Coal Ltd. will find it easy to set up JVs to supply their technology to the owners of coal mines and share the profits from the sale of gas. So I may just have to ditch the suit and dawn a pair of work scrubs on my next due diligence trip.

An Opportunity for China’s Domestic PE Industry

As the pendulum begins to swing in the other direction, domestic players may grab the best deals while foreign investors remain on the fence.

Talk to Chinese businessmen or take a walk through local malls, and it appears the Chinese don’t realize that the world is in the midst of a major recession. Last fall’s puckering contraction in exports generated wide-eyed fear in the Chinese markets, but only briefly. By early first quarter of this year, people in China were already heralding the bottom and looking forward to a quick recovery. Now Chinese entrepreneurs are once again highly optimistic about their future prospects, and consumers are swarming to hair salons and auto dealerships. All of this stands in sharp contrasts with the gloom that lingers in New York and London. And no where is the contrast greater than among investors, where local investors appear to be back in full swing, while the rest of the international investment community is still on the sidelines.

To be fair, the mood within the Western financial community has also improved somewhat since our own stock markets began to climb earlier this year and the credit markets relaxed just a bit. Nevertheless, pundits in the West continue to debate whether it is really the start of the bulls, or just a bear market rally. Meanwhile, the international investment community is looking around, but for the most part is sitting on the fence.

The few international investors that are active in China are mostly bottom fishing: they are looking for depressed valuations and offering harsh stipulations that are only found in a buyer’s market. And as long as the number of buyers remains few, foreign investors can still offer rock-bottom terms and snag great deals. For the moment, the strategy may work while the majority of foreign investors are still evaluating when and how to jump back in.

But there is no such deliberation among Chinese investors. Most are fully confident in their country’s economic future, and eager to stake their claims. And with the A-Share’s up 44% on the year, a lot more of them have money to invest again. This combination of eagerness, optimism and ability will likely give domestic investors a big leg up while foreign investors are still deliberating about jumping back in.

Over the course of the next 9 to 12 months, the confluence of an upswing in general sentiment and an increase in the number of domestic investors with cash is moving the market towards the seller. That’s not to say that we’ve reached a seller’s market yet—by any measure, it remains an extremely tough environment for private Chinese companies to raise capital—but entrepreneurs are increasingly more willing to wait for the markets to turn rather than accept a lowball offer.

Enter the domestic players. Chinese investment funds are showing an increasing willingness to invest and offering terms that, while not what entrepreneurs were receiving in the heydays of 2006 and 2007, are better than what is available from the handful of international firms which are driving hard bargains. If China’s economy continues to expand as expected, it is probably safe to assume that valuations for PE deals reached the bottom at the end of last year, and will only go up in the future. This being the case, China’s domestic players may just snatch up the best deals while most international players sleep. Even worse for the international players that stay to bottom fish, they are increasingly likely only to attract the most desperate companies—those that cant wait or can’t attract domestic capital.

Will China’s GEB Empty the PIPEs?

Chinese regulators are hopeful that the impending Growth Enterprise Board will prove to be a field of dreams for Chinese SMEs, and a serious competitor to foreign PIPEs.

Just when I thought the paucity of investor interest in Chinese OTC-listed companies couldn’t sink any lower, a friend of mine in New York asked me how China's Growth Enterprise Board will affect the PIPEs (Private Investments in Public Entities) market in China. After all, the Nasdaq-like GEB, slated to open on May 1, is intended to serve the very same small- and medium-size enterprises (SMEs) that readily flowed through PIPEs in 2006 and 2007 onto the OTC markets. Will GEB cork the PIPEs market once and for all by drawing China’s best SMEs away from a US listing? My short answer: in the short-term, “no.”

Before the world went topsy-turvy, the US capital markets were the ultimate goal for many of China's best companies; a promised land of abundant capital, global prestige and deep liquidity. For those that weren't large enough to pull a Nasdaq IPO, a backdoor listing onto the OTC markets, financed with a PIPE, was the next best thing. Cash-hungry Chinese companies going west kept bankers and investors like me busy through much of 2006 and 2007. But the flow became increasingly anemic in 2008, before shutting down completely last September, largely due to lack of investor interest. Nonetheless many in the industry are waiting for the PIPEs market to re-open, hoping to resume the party where they left off. But as China’s own capital markets become more robust there’s good reason to believe that the flow of companies westward may never be what it once was.

Having met with close to 200 Chinese management teams in the last few years I’ve come to appreciate that not every Chinese entrepreneur dreams of listing his company overseas. Rather than brave a back-door listing onto the fickle OTC market and commit to quarterly treks across the globe for investor presentations in a foreign language, many Chinese entrepreneurs are just fine to list on the A-Shares, thank you very much. But with a domestic listing out of reach for most Chinese SME's (for a number of reasons that I've discussed in previous writings), a foreign listing was their only option.

The forthcoming GEB, which boasts relaxed listing requirements, promises to change that by offering SMEs a viable domestic option for raising public capital. And with Chinese OTC-listed companies down as much as 60% or more since the market's collapse, and China's A-Shares up nearly 30% on the year, a domestic listing on the GEB looks all the more appealing. If it performs as advertised, the GEB will indeed be a competitive draw against OTC listings in the long term.

But while the "build it and they will come" philosophy worked for Kevin Costner in Field of Dreams, it often fails in business. Simply opening the GEB doesn’t guarantee there will be enough investors to provide sufficient liquidity to support a rush of SME listings. In fact, China's big boards, the A-Shares in Shenzhen and Shanghai, already suffer from a lack of liquidity, largely due to the fact that they are primarily retail markets with little participation from institutions. This, combined with regulatory hurdles, makes secondary financings and PIPEs particularly difficult in China. Given that liquidity is already a problem, opening more exchanges is likely to exacerbate the problem in the short term, spreading China's retail investor base even thinner. Only when market reforms pull in more institutional participation will the problem be resolved. And this will take time.

So when the world rights itself—hopefully sometime later this year—I expect that China’s best cash-hungry SMEs will still find the deepest pools of liquidity in New York, London, and Hong Kong. And while the GEB market may indeed draw potential listings away from the OTC market, a lack of liquidity and investor participation will soon belie the market's weaknesses. For the best Chinese SMEs, many of whom will require several rounds of financing, a backdoor OTC listing, financed with a PIPE, may yet be their best option.

The Promise of SPACs is Drying Up

The call on hedge funds is putting a deathly squeeze on SPACs, which in turn is making them a ridiculously expensive financing option for target companies.

Last week I attended the largest conference dedicated to Private Investments in Public Equities, or PIPEs, which was held in Shanghai this year. Prior to last fall’s meltdown, PIPEs were a popular method for small- and medium-sized Chinese companies to raise capital from foreign investors; usually hedge funds or private equity firms. Often times the PIPEs were executed in parallel with a reverse merger between the Chinese company and an existing shell company trading OTC (Over The Counter) in the US.

But the global financial crisis has sapped investor appetite for Chinese PIPEs, and this year’s Conference would have been more aptly named “The Creative Financing Conference.” Much of the discourse focused on other, novel ways for Chinese companies to stay afloat. This led to an interesting focus on SPACs, which are one of the few—if not only—remaining pools of capital available for Chinese SMEs looking for a public listing abroad.

A SPAC, or Special Purpose Acquisition Corporation, is like a reverse IPO; the SPAC’s management first executes the Initial Public Offering, and uses the proceeds to subsequently acquire and operate an existing company. Because the SPAC’s management is legally prohibited from knowing their acquisition target at the time of the IPO, SPACs are often referred to as “blind” or “blank check” companies. Another interesting peculiarity is that any acquisition target identified by management (post-IPO, of course) must be put to a vote from the SPAC’s initial investors, i.e. those who invested during the IPO. If the investor doesn’t like the acquisition target, she can vote “no” and recoup her initial investment along with some interest and warrants. What makes the game really interesting is that the SPACs typically must identify and acquire their target within 18 months of the IPO, otherwise they are obligated to return the proceeds to all the investors, and the SPAC is dissolved.

SPACs were all the rage in the run-up to the economic collapse. As recently as January, the New York Times cited 57 SPACs that had raised $11.3 billion from their IPOs and were still looking for acquisition targets, many of them focused on China. For the multitude of withering Chinese SMEs, the flood of SPACs looking to spend cash in 2009 beckoned like a glass of cold lemonade in this financial desert.

But after a few hallway conversations with those in the “SPAC know” at the Conference, SPACs began to look more like a mirage. To begin, it has become increasingly difficult for SPAC management teams to successfully execute their acquisitions. According to a senior executive in America’s Growth Capital, about 30 hedge funds constitute the bulk investors who have supported SPAC IPOs. And since most of them have had or are in danger of redemption calls, they are content to vote “NO” on any proposed acquisitions, take their cash, and run. Normally, 30% dissention among SPAC investors is grounds for dissolution, but in the last couple months the squeeze on hedge funds has become so tight that SPAC management now expects 100% turnover of their original investors; i.e. they expect all their investors to vote “no” no matter what acquisition target they bring to the table.

This painful reality is bad news for SPAC management, most of whom have committed a couple million dollars and two or more years of their time to their SPAC. The last thing they want is dissolution. Walking the tightrope, they are highly motivated to find a willing target and come up with innovative ways to backfill dissenting SPAC investors who are simply waiting to veto the project and cash out. This includes offering aggressive pricing to other PE investors and/or debt financing to fill the gap. But the combination of the SPAC’s management’s carry, warrants, and additional equity for debt or backfill investors piles up quickly. In some cases, the cost of capital borne by the acquired company is over 40% of the total capital received in a deal.

And therein lays the rub. For a target company to accept an acquisition by a SPAC under these terms, the entrepreneur must really be desperate for the cash. But this obvious fact doesn’t bode well for the ultimate holders of the SPACs public equity, i.e. the original investors. Indeed, many of the stronger companies that I’ve dealt with in China have elected to postpone raising capital until the financial markets come out of hibernation. With their clocks ticking, and nothing but rocks and hard places for months to come, we can expect a wave of SPAC dissolutions in 2009, as many reach their maturity date.