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Sino-Forest fraud allegations a colossal due diligence failure.
Opinion
The View
by Peter Guy
The View
by Peter Guy

Fundamental mismatch

China private equity is plagued by mediocre investment managers whose only aims are quick returns from IPOs and raise more money to earn fees

China private equity is probably the most poorly managed asset class in the world today. High-net-worth investors and family offices need to know this. As they rotate out of fixed income to seek greater returns through alternative assets, some of them are turning to or being offered China private equity funds.

The asset class is plagued by incompetent investment managers resulting in poor and inconsistent returns. Worst of all, industry wide mediocrity and inexperience among managers (known as GPs) has resulted in flawed strategies and failed due diligence.

Widespread institutional investor disillusionment with China private equity is not surprising. One of the worst symptoms is the lack of exits and realisation of returns for investments. According to estimates from China First Capital, US$100 billion of capital is locked in over 7,500 un-exited private equity deals done since 2000.

This represents a crisis never seen before in private equity. It is a direct result of an immature GP culture that in far too many cases has demonstrated abysmal decision making across entire portfolios.

Their investment methodology is based on short cuts, self-interest and far too little accountability. Their overarching goal was to make quick returns from IPOs and raise more money to earn fees.

Weak GPs are created by a shortage of local private equity investment executives who lack the historical and cyclical experience of their American counterparts. Many hires possess little real world business experience beyond running spreadsheets.

Recruiting and retaining creative and yet disciplined people with business savvy and deal sense is an absolute top priority for world class private equity managers. But persistence of returns - making consistent returns fund after fund - is nowhere to be found in China private equity. Fund managers come and go. One investor in a fund told me its management team turned over three times during its life cycle.

Worst of all, there are too many investment bankers, which means there is too much emphasis on deal making.

There is a shortage of people with meaningful investment track records or industry expertise. Unlike the US, there is little professional movement between industry and private equity. The lack of institutional learning weakens investment expertise.

This has led to a fatal misperception of risk causing a fundamental mismatch between investment structures and returns. What were really venture capital investments in risky, growth companies run by inexperienced managers were mistakenly treated as large investments in established businesses. The wrong risks were taken for incorrect return expectations. Large cap, private equity is supposed to be a stable asset class.

The results were very poor returns from 2001 to 2005 - returns that were less than two times for almost all funds, less than comparable US returns. Despite the China boom at that time, many funds lost money and failed to deliver the risk premium for China.

That China private equity delivered less than comparable US deals was ... almost insulting

That China private equity delivered less than comparable US deals was an almost insulting outcome. IPOs have been restricted in China markets so performance has not significantly improved.

Fraud, incompetence and failed corporate governance are common problems that are rarely reported.

China private equity portfolios look like high risk venture capital portfolios. So called large and established private equity firms like Baring Private Equity Asia who are supposed to make super-sized investments actually end up depending on one or two successful China investments to compensate for the rest of the portfolio's write-offs. Yet, Baring's website regurgitates business school principles of capital preservation and margin of safety in pricing which are utterly useless assessing China risk.

Allegations of fraud at Sino-Forest still represent a colossal due diligence failure that defies imagination. Sino-Forests' private equity backers were Simon Murray (Li- Ka-shing's former, right hand man and former head of Hutchison Whampoa) and his GEMS fund, which claims to possess natural resource investment experience.

GEMS' conversion to natural resources seems relatively recent as they used to be a generalist investor. Their strategy and management look more opportunistic than truly focused. The sensational accusations of the Muddy Water's research report behind Sino-Forest's price collapse literally created a new strategy for shorting overseas listed Chinese stocks.

Carson Block recently explained his methodology for analysing Chinese companies: "China is to stock fraud what Silicon Valley is to technology."

This article appeared in the South China Morning Post print edition as: Fundamental mismatch
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