What’s your best bid?

Who wouldn’t want to be a private equity investor in the Chinese tech sector at the moment? The country’s firms are at the forefront of new trends in so many fields. According to a survey by the Ministry of Science and Technology last month there are at least 164 unlisted start-ups worth $1 billion or more. Investors that bought into the early stages of these unicorns have made spectacular returns (on paper, at least).

And yet the reality on the ground is that early-stage investors don’t always get things their own way – as some of their more recent experience at the hands of top drone manufacturer DJI attests.

DJI is not on the list of 164 unicorns – the compilers seem to think the Shenzhen firm (which was launched more than 10 years ago) is too old to be described as a start-up. Nevertheless it has been raising new capital in a financing round that few Chinese private equity investors have seen before.

Many are venting their frustration about the experience to the media, perhaps fearful that other unicorns will be emboldened to follow suit.

Typical is the comment of one investor who told Caixin Weekly that DJI’s actions might “disrupt the established rules of the PE industry”.

The reason for the alarm is that DJI has ditched any pretence of looking for the kind of “strategic insight” that PE firms profess to offer. Its only interest is price – and getting as much cash as it can.

Since late March the company has been trying to raise $1 billion in an auction-style fundraising that knocks out the lowest ranked bidders in each round. And although the action has angered many of the participants who have been shown the door, it has also had the knock-on effect of lifting DJI’s estimated valuation. It was said to be worth $1.6 billion in 2014 after a $30 million investment from Sequoia. During its fundraising in 2015, when Accel Partners invested $75 million, it was valued at $8 billion. But this had swollen to $15 billion during the first round of bidding in late March, before surging to $24 billion just a month later, reported Wallstreet.cn.

DJI has also tried to sidestep the investment bankers, who typically put funds and companies together (for a price). In an email to prospective investors it warned: “There are many middlemen in the market who may tell you they can guarantee shares. Don’t be fooled or cheated by them. Our choice is only based on price.”

DJI’s founder Frank Wang is known for his forthright style. He once told journalists that he set the company up as a lark and that he takes a dim view of the human race in general. “The world is so stupid,” he was quoted as saying. “There are so many unreliable people and things.”

Now Wang has turned the joke on his investors at a time when firms are fighting hard for new opportunities. As one banker told WiC, “Institutional investors complain about tech valuations in the public equity markets. But they should see what their counterparts are having to countenance in the private equity market. It’s hypercompetitive.”

PE firms typically want to exit an investment in four to seven years. But the investment banker told WiC that recycling capital is becoming much harder, as the firms are struggling to find good entry points for new deals in the face of fierce competition.

Prospective investors have also been flagging concerns about potential exit points from DJI as the company has said that it does not intend to IPO.

Mind you that doesn’t seem to have arrested interest in DJI’s innovative financing round. To participate and show its seriousness a fund was required to not only sign an application form but also deposit $100,000. That got the PE firm into the game which then saw DJI put its so-called D-category shares and B-category shares under the hammer.

The D-shares, with no voting rights, are effectively a zero-coupon loan, with a put option three years later. The B-shares are equity with voting rights, but investors were told that their chances of getting more B-shares depended on the amount of money they were prepared to invest in the D-shares.

During the first book-building process, DJI revealed that a hundred investors had bid on a ratio of 1.29:1. This meant that for every $12,900 bid for D-shares, they would be allowed to invest $10,000 in B-shares.

Participants at the bottom of the list were then struck off and the next round of bidding began. Over the following weeks, the D-to-B ratio crept up to 1.48:1 and then 1.61:1. Some investors believe it could even hit 2:1 by the end of the process.

In the offer document, DJI said that after a three-year lock-up period it would start to offer investors two divestment windows a year when it will either buy the shares back or introduce new investors who want to bid for them. It also announced the buy-back valuations would be based on 25 times trailing earnings. By way of benchmarks the Shenzhen-listed Hikvision – the world’s largest surveillance manufacturer – is currently trading around 37 times trailing earnings, while Hong Kong-listed Sunny Optical (which makes drone camera parts) at about 40 times. Given that both companies are listed, getting in and out of them is also much more straightforward.

Netizens have mixed feelings about DJI’s “fundraising stunt”, as Reuters Breakingviews puts it.

Reacting to a Tencent Tech piece, one said of the dual-share offer: “Remember the old saying about things needing to offer value: ‘buy beer and you’ll get peanuts’. Well here DJI expects investors to not only provide the peanuts but the salt to go on them too. These are not good terms. There’s no dividend and no IPO.”

Others disagreed. “DJI is an amazing company. And here they are selecting the investors they want, not the other way round,” said one.

“Yes, and investors have no choice in this industry, because DJI is king,” another replied.

DJI dominates the consumer drone market with a roughly 70% share worldwide. This resulted in revenues of Rmb17.6 billion ($2.8 billion) in 2017, up from Rmb5.98 billion in 2015. Net income came in at Rmb4.3 billion. Now it is hoping to drive revenue growth by shifting into more sales of commercial drones for use in agriculture, energy, construction and infrastructure. Research firm IDC forecasts the industry as a whole will enjoy an annual growth rate of 30% over the next five years, with commercial drones rising to about 50% of total sales.

Rule changes in China – where the government released new guidance on drone regulation earlier this year – may help.

Previously, all drone flights were supposed to get approvals in advance, even if they were just piloted by amateur hobbyists. Now there are plans to allow micro-drones more freedoms (outside no-flying zones) without pre-approvals as long as they log their flight paths in real-time. All of DJIs drones also incorporate geofencing technology, which blocks them from flying into unauthorised areas.

This week DJI began circulating the findings of a report from San Francisco-based Kivu Consulting, which specialises in cyber security and data breaches. The study was commissioned in response to concerns in the United States that the drone fleet could be used to transmit sensitive data back to China (DJI described the claims as “utterly insane”).

Kivu’s findings were that users of the drones keep full control over how information like photos, videos or flight logs are collected, stored or transmitted. “This is the first time that DJI has allowed outsiders to examine its proprietary computer code, and the result is the first independent verification of what we have said all along: DJI provides robust tools to help our customers keep their data private,” said Michael Perry, DJI’s head in North America.

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