Worst case scenarios: How GPs recover value

The deterioration in relations between CVC Capital Partners and Lan Zhang, founder of Chinese restaurant chain South Beauty, went from rumor to media reports to publicly disclosed legal action within the space of a few weeks. The GP has now exited the investment, with nothing to show for it, and creditors have brought in restructuring experts to see what they can recover from the situation.

Before that, in March, it emerged that CVC and Zhang were involved in arbitration over the transaction, which last year saw the PE firm pay around $300 million for a majority stake in South Beauty. CVC also obtained a court injunction to freeze the founder's assets. Upholding the injunction against Zhang and two other entities, a Hong Kong judge noted that "very substantial sums had been paid by them [CVC] and it is still unknown where those sums now are."

The ruling did not explain the nature of the dispute between the parties. However, it has been suggested that South Beauty's earnings were artificially inflated ahead of the deal closing - just as other restaurant chains were beginning to feel the pinch of Beijing's efforts to rein in spending by government officials. If there has indeed been fraudulent activity, CVC will want its money back and freezing a person's assets is one way of encouraging them to pay up.

The circumstances are far removed from those under which the transaction was struck. Zhang said that CVC's vision "highly aligns with ours in respect of brand positioning, future growth areas, corporate culture and values." Francis Leung, managing partner at CVC, in turn praised the South Beauty management team for its "deep industry insights and knowledge as well as strong execution capabilities."

The language is not unusual for investment announcements. At this point in the process interests are aligned and there are hopes of future growth. But during these halcyon days, how many GPs think carefully about what happens if the deal turns sour? This has implications for transaction structuring and how PE firms can recover value in a worst case scenario.

Taking action

According to Velisarios Kattoulas, CEO of The Poseidon Group, which provides due diligence, risk analysis and consultancy services, one in five failed investments are the victims of market conditions. In the other four cases, the problem is the management team. A good management team, even when paired with a poor business idea, can deliver strong performance. The converse is not true.

"A bad management team and a good idea - that is where people encounter the most trouble. They fall in love with the idea but the management team isn't up to snuff and things go wrong," Kattoulas says. "I know a PE firm that invested in bricks and mortar retail not long ago. It shouldn't work - we are all shopping online now - but it's been a brilliant investment because the management team is great. I've seen other funds go into China healthcare with a bad management team and it's been a disaster."

There is often a common factor driving these deals: PE firms are under pressure to deploy capital in a highly competitive Asian landscape. This may lead investors to overlook weaknesses, compromise on terms and cut corners on due diligence in order to win over the entrepreneur and get the transaction closed quickly.

A bad management team and a good idea - that is where people encounter the most trouble. They fall in love with the idea but the management team isn't up to snuff and things go wrong - Velisarios Kattoulas

GPs can be divided into three broad categories as to the aggression with which they seek a resolution. First, distress investors are used to dealing with problems and unafraid of getting adversarial. Second, credit and special situations players tend to be highly attuned to downside protection and how the capital structure can be used to secure their interests. Third, generalists, particularly minority investors, are sometimes reluctant to get their hands dirty.

"PE investing is about having one or two really good hits, which more than make up for ones that aren't so good," says Chris Leahy, co-founder at Blackpeak Group, a strategic advisory firm. "If something is bad or unlikely to be resolved, so there is a sense they might be throwing good money after bad and damaging their reputation in the market, they might decide enforcement is not the best use of their LPs' capital."

In this context, there is a general desire for resolutions negotiated outside of the public domain. Arbitration is therefore an attractive proposition. Unlike litigation, it is private and there are typically no appeals. However, arbitration can also be expensive and may limit an investor's options. While an international arbitration award is enforceable in China, for example, it can take time, and some industry participants advocate going through the mainland courts directly.

Swift action is particularly important, given the local party might have transferred assets out of a joint venture company by the time a court endorses an arbitration ruling made overseas. "You go through a very extensive legal process and you don't know what is going to be left of the company at the end," says John Lees, managing director at JLA Asia, a forensic accounting and insolvency management consultancy.

David Mahon, managing director and CIO at Mahon China, which advises or represents investors in distress situations, adds that where the Chinese legal system is lacking, relationships must come to the fore. Although the courts have become far more efficient, local government officials are often best positioned to encourage counterparties to reach a settlement.

"You have to bring in official support at the very beginning, during the investment and certainly when there are problems. Too many foreign investors look at it and say, ‘Here's the contract, if we have a problem we can go to court.' And too many of them try to establish arbitration outside of China, which often does nothing to help in China."

In addition, arbitration agreements are bound by their wording. There are situations in which clauses do not clearly define the dispute that has arisen and then they only apply to the people who are party to them.

PE investors enter investments with a broad idea of their potential exit routes. The same strategic thinking should go into how to recover value when things turn sour. If a GP ends up in litigation or arbitration, how can it maximize its ability to win the argument and recover any damages that might be awarded? It is not only a case of whether an arbitration clause should be used and how it is worded, but also the jurisdiction in which a dispute will be resolved.

"Sometimes not enough attention is paid to the dispute resolution clause generally. That is partly the lawyers' fault. The people who put these agreements together are not normally litigators so they come at things from a different perspective," says Mark Johnson, a partner and member of Debevoise & Plimpton's international dispute resolution group. "There is a lot more coordination between corporate and litigation lawyers than there used to be, but there are still occasions where people simply pull something off the shelf and it might not be the right clause for a certain type of agreement."

The standard downside protection for minority investors is a put option - redeeming a position and taking the assets held as security.

For China investments, this security often takes the form of shares in the offshore vehicle pledged by the founder; and so enforcement hinges on a local court accepting that the foreign party can enforce against a wholly foreign-owned enterprise (WFOE). Alternatively, the investment might be structured as a Sino-foreign joint venture, which means action can be taken directly onshore.

On top of this, there might be unsigned letters of resignation from the founder's representative board members and share transfer agreements held in escrow and released to the investor if there is a desire to claim the security and assume control of the company.

The threat of legal action is intended to encourage founders to negotiate. For example, once a shareholder in a small company is forced to consider the financial implications of contesting a court case - the costs might amount to the value of the company itself - he is likely to appreciate the merits of a settlement.

"We are always ready to talk and get a solution rather than rely on a process," says Mahon. "In China, once you have engaged with the court then often there is a reluctance to talk. There is either a belief that the process will go on for a long time and the foreign investor won't get the satisfaction they expect, or there is a polarization in the relationship itself. Litigation is a last resort."

Forcing the issue

There are, however, cases in which PE firms have gone to great lengths in order to achieve a desired outcome. Warburg Pincus pumped $215 million into Titan Petrochemicals, a Hong Kong-listed shipping and oil storage company, only to see the business struggle in the wake of the global financial crisis. The GP also found evidence that senior executives had secretly provided unauthorized guarantees to subsidiaries in order to keep them afloat, leading to significant damages and potential liabilities.

These details emerged in a 2012 Hong Kong court filing that was part of a multi-jurisdictional effort. Warburg Pincus exercised redemption rights on securities issued by a Titan subsidiary in the British Virgin Islands, and then asked a court to liquidate the business. It also announced plans to redeem shares in Titan and later asked a Bermuda court to start liquidation proceedings.

Titan was also looking for solutions, lining up oil and commodity trader Guangdong Zhenrong Energy as a buyer for a controlling stake in the Hong Kong-listed business and for Warburg Pincus' interest in several other assets. The agreement was conditional on the lawsuit being dismissed and court approval of a debt restructuring plan. Warburg Pincus duly exited and the restructuring proceeded.

"The exit was planned before we took the first step towards enforcement," says one lawyer who worked on the deal. "No one should go into these situations blind, without identifying who are the potential investors to take you out. The enforcement process was executed in a relatively short space of time - 2-3 months."

More recently, L Capital Asia took portfolio company Jones the Grocer all the way into insolvency in order to secure a desired outcome. The gourmet food retailer has operations in Australia and Singapore and so proceedings were instigated in each jurisdiction, with the private equity firm successfully bidding for both sets of assets out of administration.

According to a source familiar with the situation, L Capital "partnered with the wrong guy," and he remained CEO after the PE firm invested in Jones the Grocer in 2012. The parties were unable to work together and the structure of the investment agreement made it difficult to replace him, hence the decision to enter administration and start again.

"This is a means by which a shareholder can take control of the investment in circumstances where another shareholder is, for example, mismanaging it," notes Randall Arthur, a partner at Kobre & Kim who specializes in insolvency litigation.

"I previously acted for the provisional liquidators of a company that had two directors, one of whom wasn't pulling his weight and wasn't financially able to inject further capital into the company to keep it afloat. The other director was willing to take over the company and inject further capital but couldn't reach an agreement with his fellow shareholder. He therefore called on some loans he had made to the company, forced it into provisional liquidiation and then, with the sanction of the court, acquired the company from the liquidator."

You look for evidence of property ownership in enforceable jurisdictions - moveable assets, lifestyle assets like fine art, jewelry, luxury cars, boats - and try to build a picture of what assets might be available in a valid claim - Chris Leahy

In situations where a founder has misappropriated assets from the company and placed them under new entities in his own name, investors can ask the courts to unwind these transactions. Similarly, if it is possible to prove fraudulent activity, personal assets held by the founder might be attached to the case and used as leverage, or even seized. This often involves identifying assets in jurisdictions where enforcement is seen as easier.

"You look for evidence of property ownership in enforceable jurisdictions - moveable assets, lifestyle assets like fine art, jewelry, luxury cars, boats - and try to build a picture of what assets might be available in a valid claim," says Blackpeak's Leahy. "A mareva [asset freezing] injunction is helpful because it can flush out where cash deposits or significant assets are held."

It is also possible to take action against directors of a company who are engaged in conduct that is in breach of their fiduciary duties. Kobre & Kim's Arthur was previously involved in a case in which the directors of a Singapore company passed resolutions to pay themselves dividends as shareholders despite the business being insolvent. The directors owned properties in Hong Kong and there were indications these would soon be sold, so an injunction was obtained to freeze the assets.

"It wasn't enough to cover the full claim in Singapore but it covered a substantial amount of it," says Arthur. "And it did cause the directors to enter into settlement discussions with the liquidator."

Be prepared

When consultants are brought in to provide advice on troubled investments, they are not just looking for assets to pursue. A fraud investigation must begin with an understanding of what exactly has gone wrong and who is at fault. The counterparty's misbehavior could have been prompted by any number of factors, ranging from financial distress to third-party litigation to family problems, and the investor can only decide how to proceed towards a settlement once in possession of the relevant facts.

There is a striking resemblance between the issues that emerge during these processes and the areas of examination in deep pre-deal due diligence: how the business was founded and achieved scale; the founder's track record, including how he has treated partners, creditors and employees, particularly in times of stress; the management style and how the company is perceived by customers, suppliers and competitors.

It raises the question of how many distressed situations and dispute resolutions could be avoided by investors doing their homework before putting any capital to work. "It is a good step to do as much due diligence as possible on the entities and individuals being invested pre-acquisition so you know any potential obstacles," says Keith Williamson, head of the global forensic and dispute services team in Hong Kong and China at Alvarez & Marsal.

The consensus view is that most private equity firms, wearing the scars of past mistakes, are willing to spend more on minimizing their downside in this respect. Investigative due diligence is increasingly seen as part of the standard process alongside legal, financial and operational analysis. More attention is also being paid areas such as political and regulatory risk and competitor analysis.

With larger sums at stake - and in an environment of slower growth and rising valuations, which means that private equity firms must work harder for their returns - there is greater willingness to give third-party services providers the resources and time to perform tasks to an appropriate level of detail. That said, industry participants say there remains a divide between those firms that ask for a completely non-jaundiced assessment of management teams and those that reduce due diligence to a box-check, affirmation exercise to be completed in two weeks.

"Once things have gone wrong there is not a lot you can do to turn things around. You need to be very lucky, and generally people aren't lucky enough," says Poseidon's Kattoulas. "The far smarter thing is to limit the possibility of these things happening in the first place. You have to be very rigorous going into relationships and transactions and then using sufficient resources to monitor things properly."

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• Topics
• Regulation
• Credit/Special Situations
• Restructuring
• Greater China
• Asia
• China
• regulation
• Distress
• professional services
• CVC Capital Partners
• Warburg Pincus Asia