Private equity gambling
International investment funds' poor reputation on the mainland can be blamed on a prohibitive contract clause which has caused bankruptcies
Private-equity investors in China may have to worry about their reputations among mainland entrepreneurs, thanks to several unhappy cases of private equity investments that seemed more like gambling than investing.
Private equity has a brief history in China compared with its decades-long track record in the United States and Europe. In recent years, a growing number of mainland firms have turned to global private equity firms such as KKR for money, partly because Beijing tightened credit to stop the mainland economy from becoming overheated.
Some mainland firms backed by private equity money have grown well. For example, China Pacific Insurance went public and expanded its business with the help of Washington-based Carlyle Group, one of the world's most powerful private equity firms, which also made huge profits from its investments in the mainland's No 3 life insurer.
But some firms became victims of the capital game, with mainland entrepreneurs often complaining about the so-called "valuation adjustment mechanism" (VAM), also known in the mainland's investment community as a "gambling term".
VAM is a contract clause which private equity often uses to protect the value of its investment in a company. The mechanism gives private equity effective control over the future value of their investment should certain events occur or not occur. If the company does not hit certain targets or achieve a particular transaction, then the investor is legally entitled to extract certain financial concessions.
Some private equity firms want their investment targets to add the VAM term in their deal agreements to guarantee profits. For example, the company may be required to meet certain growth targets in an agreed period of time, typically two or three years. Then its private equity investor can decide to increase or withdraw its investment, or offer to buy out the company from other shareholders - if the company misses its targets - which can turn into a disaster for the founders of the company, who might lose control.
"That's why many Chinese entrepreneurs call the condition a 'gambling term', because it can lead to a company and its private equity investors getting stuck in a situation like gambling," said one private equity industry veteran who declined to be identified. "But to be fair, if your company can meet those requirements, then nobody will lose anything."
The "gambling term" is not unique for deal-making in China, since it is also sometimes cited in investments that happen in New York or Dubai. But privately some investment bankers say private equity funds do use the condition much more often when they invest in China, in particular in small- and medium-sized enterprises on the mainland.
Part of the reason why "gambling terms" appear more often in mainland investments is that many foreign investors lack confidence in the mainland's judicial system, which is not completely independent and often highly influenced by the government, so they have to add more conditions to guarantee and protect their interests, industry executives say.
Some executives cite the recent example of Beijing-based South Beauty. A mainland chain restaurant operator well-known for spicy Sichuan cuisine, South Beauty was founded several years ago by Zhang Lan.
The firm hired three investment banks to help it get a listing in Hong Kong. It aimed to raise up to US$200 million through its initial public offering (IPO) of stocks in Hong Kong before the end of this year.
Now Zhang faces the risk of losing control of her company if its IPO does not proceed this year, thanks to the "gambling term" which she agreed to sign when private equity firm CDH paid 200 million yuan (HK$247.2 million) for a 10 per cent stake in 2008.
Zhang agreed with CDH that if South Beauty failed to go public before the end of 2012, she would buy back CDH's shares for about 400 million yuan, or twice its original valuation. If she can't come up with the money, it will be a potential financial disaster for her and the restaurant empire she founded almost from scratch.
In this gambling-like capital game, South Beauty is not alone. Previous cases include Hunan Taizinai, once a famous local dairy brand that went bankrupt in 2010, and China Paradise, a leading mainland home appliance maker invested in by Morgan Stanley and later acquired by bigger rival Gome.
"Many entrepreneurs dislike those 'gambling terms', which put them under huge pressure for business growth, and that may also explain why corporate frauds and accounting irregularities of mainland companies have been on the rise in recent years," said an investment banker at a major firm in Hong Kong.