Private equity gambling

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."