Deciphering a company in China is much harder than in most other places worldwide and investing in Chinese businesses therefore requires extensive due diligence and careful deal structuring that wouldn’t be necessary in the West, according to a panel of industry professionals at the Milken Institute Global Conference 2013 in Los Angeles.
“China is a more difficult place than most,” said David Bonderman, founding partner of TPG Capital, adding that Chinese businesses often operate with standards “not consistent with Western accounting practices”.
“There is a class of people, many of whom are now listed on NASDAQ, that seem to regard numbers as an art, not a science.”
In one company TPG looked at, the business structure was so complex the firm inserted undercover employees in the business who then revealed its accounting was “entirely fraudulent”
David Bonderman, founding partner, TPG Capital
In 2012, about half of China's 1,689 listed non-financial companies were suspected of having offered inaccurate data in their financial reports, according to data provided by Bonderman who cited various sources.
Subsequently, China's regulators froze approvals of all new IPOs and on 8 January 2013 announced all pending IPO applicants should be investigated. By the beginning of April, 166 companies had withdrawn their applications, with others trimming their profit forecasts.
Firms must take measures to protect themselves, panelists agreed. Bonderman explained in one company TPG looked at, the business structure was so complex the firm inserted undercover employees in the business who then revealed its accounting was “entirely fraudulent”.
Firms can also mitigate risks by protecting themselves through the deal structure, said Benjamin Fanger, co-founder and managing director of Shoreline Capital, a distressed debt and special situations investor in China.
For example, it is easy to access information in China about the assets a company owns, therefore Shoreline will often use these as collateral by taking over ownership of the title until after the debt they’ve provided has been paid back, with the return.
“We’d rather just be holding the asset,” Fanger explained. “We’ve been in over 300 law suits in China enforcing the distressed debt that we’ve purchased and we know that we’d rather not be in a Chinese court trying to enforce debt that we’ve funded at 100 cents on the dollar.”
Shoreline has approximately $500 million in assets under management in China, Fanger said. He explained that many foreign investors misunderstand Chinese companies, which is the main cause of issues that arise post-investment.
“A lot of this talk about Chinese companies being fraudulent and trying to screw you, a lot of it is completely unfair. I was on a panel a few years ago when a guy said nine out of 10 Chinese companies are fraudulent and I fell out of my chair because the truth is [that] nine out of 10 foreign-invested companies in China actually are not frauds, what they are is a company that the investors don't understand.”
Due diligence and board representation is not enough to get comfortable, therefore Shoreline will tell the borrower on what basis it will offer financing, which could require them to hand over assets or quite often the company “chop” (the company seal required to transfer assets).
However, Fanger also described one case where fraud actually benefited the firm. Shoreline acquired a non-performing loan from a state-owned enterprise at “close to zero because there was nothing left in the company”. The firm went through the company records and found that all the assets had been transferred to a relation of somebody in the management at the SOE. The firm went to Bureau for the Protection of State-owned Assets, but the local government was reluctant to take legal action.
We've sort of relied on this local government versus Beijing government [dynamic] many times
Ben Fanger, co-founder, Shoreline Capital
“We were really excited to find this out,” Fanger explained. “The management or borrower doesn't want to go to prison, the local [government] doesn't want us to disclose to the Beijing Bureau for Protection of State-owned Assets that this has occurred, so when you pay one cent on the dollar for this non-performing loan and you have that amount of leverage, you get paid a very good return to go away. We've sort of relied on this local government versus Beijing government [dynamic] many times.”