Russian roulette for PRC investing
Russian roulette for PRC investing
By Maya Ando
The most populous country in the world, China, has been made out to be something of a promised land for private equity.
Demographics, growth and companies making everything under the sun all contribute to what could be a perfect storm for double-digit returns.
With 35% of China’s population living in large cities, and with a continual migration from the rural countryside to urban areas, a growing middle class consumer base is increasingly willing to spend more money on the wants in life: a nicer house, a better car and international brands of clothing and accessories. Add to that China’s status as producer of all goods to the free world, and there is no shortage of growth and opportunity. While investors certainly do not want to miss this golden opportunity; what is the cost where unforeseen risks are concerned with a China allocation?
More money, more problems
Looking back 10 years, the cost of labor to produce goods in China was as little as RMB700 ($104) per month for a factory worker. Today, these same workers know they are fundamental to China growth and as a result have found their voice. One example of this is recent news of a strike led by factory workers at the Tianjin plant of Japanese automotive maker Toyota. Demands for pay rises are becoming increasingly common as employees at every rung of the ladder look to reap the benefits of China Inc. For investors, this is a real risk, and this kind of human risk cannot be predicted nor accounted for while poring over financial figures, sales and revenue forecasts.
Then there is the propensity for questionable information disguised as facts and figures. Blatant lying (Chinese Olympic gymnasts? Infant milk powder? Financial records audited by the founder’s cousin?) is something that is still a part of doing business in China. Shenzhen Airlines, 65% owned by Guangdong Development Bank and 10% owned by Shenzhen Investment Management, was recently found to have hired 103 unqualified pilots just to cope with expansion. A further inquiry resulted in the outing of more than 200 pilots hired by another local airline, all of whom had falsified their flying histories simply to get a foot in the door.
These kinds of scandals affect stock prices, asset valuations, and the reputation of the investor. But the fact of the matter is that human risk is everywhere, and although the legal system in the PRC requires full disclosure, these kinds of fraud issues are omnipresent. As every emerging markets investor knows, there are higher hidden risks everywhere; the trick is knowing how to find them.
Private equity players look for risks in a variety of categories, including: human risk, industry risks, legal risks, compliance risks and currency risks.
GPs understand this all too well, but one of the complaints AVCJ hears from them is that LPs want quick results – results that at times can mean cutting short a proper and comprehensive due diligence process. While LPs may theoretically understand the time and expense necessary, the desire to see returns can trump all. Large buyout funds sitting on dry powder are feeling the heat from LPs that expect them to find the mid-market deals they were promised; in more mature markets, of course, larger deals are easier to come by – and to diligence. In China, the background checks require more than Google search.
Lessons learnt the hard way: The story of GOME and Bain Capital
A rising tide lifts all ships; so too in an emerging market. But what also tends to rise is the sense of self-importance and greed on the part of founders who have hit the jackpot. GOME Electrical Appliances Holdings Ltd. is a good (or bad) example. Founder Huang Guangyu started the business honestly and humbly, by collecting discarded electric goods from the street, fixing them, and selling them. He later opened a small shop and then grew the company into an incredibly successful, nationwide retailer. GOME brought him fame, billions of dollars in personal wealth, and a flawed sense of invincibility. Huang is now famously serving sentence for a number of crimes, including insider trade and manipulating the company’s share price.
The media frenzy surrounding GOME was in part because in June 2009 US firm Bain Capital bought a significant minority stake. And while there is no doubt that Bain did its due diligence, industry sources say there is “no way” Bain did not know the extent of Huang’s issues. “They thought the situation could be controlled,” said one, noting that certain GOME shareholders that appear to be supporters of Huang still manipulate GOME’s management. Irrespective of any wrongdoing, there is a strong cultural sense of loyalty to a founder someone has worked with for years.
For Bain, however, this must be a constant headache. Not simply in dealing with Huang – who has a certain penchant for writing strongly worded letters and trying to oust Jonathan Zhu from his Board seat – but in answering to LPs. By ridding the company of the root cause of the problem, Bain thought it would kill the virus.
However, it is proved not to be that simple. Zhu himself said in an interview, “It’s certainly a hairy situation.”
But for every tale of woe, there are also the countless investments that do make a tidy return, and are the catalysts for investment theses that make China a core investment destination.
Getting your hands dirty
Kenneth S. Springer, a former FBI agent who is founder and President of Corporate Resolutions Inc, toldAVCJ, “Based on my 20-plus years of conducting background checks, the most important thing to keep in mind is that it’s not what they tell you, but rather what they don’t tell you. Often, it is these half-truths which are the indicators of fraud.” He explains, “We don’t always find records indicating someone has previously perpetrated a fraud, but rather the indicators [which] if you connect the dots often spell out fraud.” Springer intimates that much of it comes down to a gut feeling. “Sometimes you have to sit back and say, ‘What’s wrong with this picture?’”
For example, Bernie Madoff, Allen Stanford and Danny Pang did not have criminal records. “The key to gathering all the facts is to analyze the discrepancies, controversies, reputational issues and problematic patterns. The most common findings of our global background checks are material non-disclosure and problematic patterns of lawsuits.”
He warns that when looking through a Western lens, the amount of publicly available information on companies, people and events in emerging countries like China and India generally is not sufficient enough to base significant investment decisions. “Often, the bigger risk is not financial risk, but reputational [as concerns the investor].”
In the US, the Foreign Corrupt Practice Act (FCPA) is receiving a great deal of attention because it seriously impacts the due diligence process for US investors in emerging markets. Effectively, all US companies investing abroad must be cognizant of the moves foreign subsidiaries are making, as there can be both financial and criminal sanctions if any employee or any agent working on their behalf makes any type of payment to influence government officials. Companies and funds therefore have to implement compliance programs such that portfolio companies can demonstrate – if necessary – that they are abiding by all aspects of the regulations.
To try and meet these goals, Springer advises that public record information gathered must be complemented by independent third parties and industry sources to ascertain one’s reputation and that of their company(s) as well. His company recently worked on a case on behalf of several US-based investors that highlighted the potential ramifications of FCPA; the issue involved a US company acquiring a group in India that subsequently made bribes to public officials. The investors learned their lesson about policing portfolio companies.
Due to the risks involved in investing in an emerging market, companies like Springer’s are cropping up more frequently across China. “The market is huge, so we currently cover core cities like Shanghai, Beijing, Guangzhou, Tianjin, Shenzhen and Chongqing, where a large number of investors are seeking out investment opportunities.” He also noted, “It is more difficult to conduct an adequate background review of entrepreneurs in some of the more remote areas of China.”
Dane Chamorro, Managing Director for Greater China/North Asia at Control Risks, told AVCJ, “It is very difficult to double-check a company’s financial information – particularly a privately held company – unless someone is actually inside. Even if financial flows are accessible, the information is very difficult to verify; sometimes it may even be fake. This aspect of doing deals is very challenging for private equity players,” which is where third parties come into the picture.
Apart from checking financial status or background, a risk firm will investigate the company’s owners and their personal life, communicating with former employers and employees, neighbors, friends, industrial sources and insurance policy records. Usually, the process takes about a month for firms in India and China.
Even if a founder is clear of past issues, one common problem that crops up all too often, but is rarely discussed in anything but hushed tones, is the behavior of company founders who are accustomed to having full control over their company. Even if a founder exits fully or reduces shareholding to a minority stake, managing the portfolio company can be difficult. “Founders may exit and then establish a rival company” down the road, explained Chamorro.
Foreign investors that formerly had regional office in Hong Kong now realize that it is essential to have professionals with deep knowledge of the local culture and business landscape to monitor the China market from within China. PE firms such as Kohlberg Kravis Roberts, Carlyle, Blackstone and TPG have all set up offices in either Shanghai or Beijing, able to leverage personal networks and wider associations to investigate the company through sources and contacts outside the private equity sphere.
The first thing foreigners learn, said one source, is that academic backgrounds do not mean anything in China. Personal networks and the ability to source information “is king.”
Another private equity executive told AVCJ, “People come in here doing traditional PE; one thing is they think they can add value to companies with corporate governance or management expertise. But if you look at the guys who run traditional PE, they do not have much management or operational experience.”
Generalizing, he said that most of the executives that fall into this category are MBA graduates, and while some of them speak Mandarin, they have no experiences in operating companies, much less companies in China. “So I don’t know how they can add value. Can they really improve corporate governance? I doubt it.”
Local knowledge and cultural sensitivity trumps all in a market as complicated as China, where understanding the people is central to being able to detect hidden. China and India are developing markets; the systems and paths to economic success are just that – developing. So at least for now, private equity firms will need a healthy dose of skepticism, a qualified risk partner, and a team that knows who to turn to, what to ask, and how to qualify the answers.
China is rich with opportunity – for those that know how to play their cards right.