China growth deals: Of entrepreneurs and egos

Like many disputes in modern China, a shouting match between the founder and an investor in one of the country's largest lighting products manufacturers has found its way on to Sina Weibo. In one corner is Changjiang Wu, founder and chairman and of Hong Kong-listed NVC Lighting; in the other, Andrew Yan, managing partner at SAIF Partners.

The conflict dates back to May 25 when Wu resigned his position and was replaced by Yan. The latter then took to Weibo, the largest micro-blogging platform in China, saying the former fully supported the board's decision. Another post written in July suggested that Wu should learn to be "a more mature and self-disciplined modern enterprise manager."

Around the same time, local media reported that NVC's investors - including SAIF, the second-largest shareholder and a backer of the company since 2006 - had accused Wu of weak corporate governance and involvement in related-party transactions.

Wu's rebuttal came two days later. He claimed Yan told him on May 21 that the board demanded he resign as chairman, CEO and from all positions with NVC's subsidiaries. "Yan forbade me from speaking to the media and using Weibo, but then he talked to the media himself and published insulting posts directed against Chinese entrepreneurs," Wu added. "If I don't speak, people will never know the truth."

Since then, workers at NVC have demanded the reinstatement of Wu, suppliers are reportedly refusing to do business with the company, and three senior executives quit in the space of two days in mid-August. NVC shares have slipped 36% since late May, suggesting the spat has wiped $325 million off the company's value.

"When you come across a case like this, it's difficult for a private equity investor to handle the situation effectively because they have already generated so much public tension," one of SAIF's LPs tells AVCJ. "They should have settled it earlier and in a quieter manner."

Outsize personalities

Conflicts between entrepreneurs and PE investors are not unknown in China's personality-driven economy. In some cases, the quantitative and systematic pursuit of financial targets favored by investors is not aligned with the goals of entrepreneurs, who have built their business on large personal networks of upstream and downstream partners, which can obscure accountability.

"In a China context, common problems include related-party transactions and internal conflicts as to how a business should be run," says Chris Leahy, co-founder of risk advisory firm Blackpeak. "Sometimes entrepreneurs just work for their own good and a variety of outside interests, rather than for the benefit of shareholders as a whole."

Tensions don't necessarily arise from alleged illegal activity. Many entrepreneurs, who might be aged 30-50 and still actively involved in the business, fail to appreciate private equity investors' long-term agenda and value-add, seeing only a one-time capital hit to support their immediate expansion plans. Financial targets may change over time as new opportunities emerge, particularly in early-stage firms that are more intuition-driven than institutionalized.

Last year, Lan Zhang, founder of restaurant franchise South Beauty, told media that one of the company's biggest mistakes was allowing in CDH Investments, which she claimed put in a small capital but took a significant stake in the business.

In 2008, Zhang reportedly met CDH's Gongquan Wang at a party and they reached a deal several months later. CDH and China International Capital Corporation subsequently paid some RMB300 million ($43 million) for a 10% stake in South Beauty. Zhang vowed to set up 100 restaurants by 2009 but the company was only halfway there as of 2011. CDH was said to be unhappy South Beauty's failure to reach its target.

Know your entrepreneur

There is no doubt that carrying out in-depth due diligence before signing off on a deal means investors can avoid those with explicit governance flaws. However, there is no blood test to ensure CEOs and other senior executives will be as clean and cooperative as expected.

Bain Capital, for example, conducted comprehensive due diligence prior to making its $446 million investment in Gome Electrical Appliances in 2009, but it didn't foresee the battle for control that ensured between the company's imprisoned founder, Guangyu Huang, and its follow-on chairman Xiao Chen.

"We thought that risk could be managed because there is a fundamental alignment of interests," Jonathan Zhu, managing director of Bain Capital Asia, told AVCJ last year when looking back at the deal. "The business risk was limited and the financial risk was almost non-existent. How many retailers are there in the world sitting on a net cash position?"

Zhu added that the investment in Gome was still profitable despite the tensions that haunted the business for nearly two years.

Blackpeak's Leahy shares a similar view. Given that many of companies targeted by private equity players wouldn't have found success without founders' strong ties to various stakeholders, he suggests that third-party investors establish an alignment of interest with entrepreneurs and other parties as soon as the investment takes place. This is preferable to avoiding influential founders and potentially losing out on growth opportunities.

Mandarin Capital took this a step even further, reaching out to existing management at Dagong Europe Credit Rating, a China-based credit rating agency, four years before making its investment, which finally went through in March.

"Successful relationships with Chinese entrepreneurs may cost you a long period of time and efforts," says Alberto Forchielli, a founding partner at the Sino-European private equity firm. "It's important for entrepreneurs to share your objectives, cherish your advice, as well as maintain a certain degree of autonomy."

Face-time is important. Rather than just showing up at board meetings once a quarter and making suggestions as to how a business should be run, private equity investors - even those in minority positions - should better integrate themselves into portfolio companies' daily operations. It is a case of proving to entrepreneurs that you can add value.

"Most situations can be worked out if you are there every day," says one China-focused mid-market GP. "If you are not there, do not deal first-hand with the problem, or are just a passive investor, you can only do exactly what you do when your favorite stock price falls: sit and watch."

If left to fester, problems can overwhelm the business, as evidenced by NVC. When any chance of reconciliation and realignment is past, a private equity investor is left with two options: take control of the company, restructure it and look to make a profit, or cut your losses and get out as quickly as possible.

"It's a game of poker and you always need to understand your counterparty," says Blackpeak's Leahy. "But whichever is considered a better choice, you need to motivate the entrepreneur in a less hostile way so that the suggested solution will work in his best financial interests."

Stick or fold?

Yan appears to have taken the first approach regarding NVC. SAIF was reportedly able to dismiss the chairman by allying with other investors including Goldman Sachs and Schneider Electric. The three parties currently own 33.36% of the company, compared to Wu'S 19.53%. Yan also publicly set out his stall, declaring that the private equity firm would not back down despite massive protests. "In the worst-case scenario, we go and find new distributors and the company's stock will suffer for about two years," he said, cited by local media.

However, restructuring requires a lot of time and effort. When CITIC Capital and Warburg Pincus invested in state-owned enterprise (SOE) Harbin Pharmaceuticals in 2005, they discovered the general manager of one of the company's subsidiaries had constructed an imitation 18th century Rococo-style palace as its headquarters. It was a classic case of an SOE using excess as a means of discounting economic returns, but removing the manager responsible risked undermining the fabric of the company.

The investors had to wait four years for the individual to retire. Around the same time they finally completed the centralization of Harbin Pharmaceuticals' financial structure, after facing down resistance from managers of subsidiaries desperate to hold on to power.

Comparisons between Harbin Pharma and NVC are tricky, though. One is an SOE still controlled by PE investors who have yet to exit. The other is a private enterprise that has already achieved a public listing, which generated a significant paper gain for its investors. The SAIF LP argues that it makes more sense to exit than hold on for another three years.

"It's a general rule that a GP should target an exit after capturing significant returns via an IPO," says the LP. "If your final goal is to get out as quickly as possible, it is best to sit down with the entrepreneur quietly and give him the face, instead of making a fuss."

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• Topics
• Greater China
• People
• China
• SAIF Partners
• CDH Investments Management