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Great Recession Watch ? Living With Mendacity in China

By Stan

“You said it yourself, Big Daddy. Mendacity is a system we live in.”

–Brick, Cat on a Hot Tin Roof

As usual, Tennessee Williams is a good place to go for wisdom. As the Great Recession rolls over us, information about the financial system, built on a lot of mendacity, is coming to the fore.

This morning, I thoroughly enjoyed reading Matt Taibbi’s latest column in Rolling Stone about the economic collapse and the reasons for it. In discussing collateralized-debt obligations (CDOs), one of the new “products” brought to us by the financial services industry, Taibbi explains how these instruments were a bit less sound than advertised:

The problem was, none of this was based on reality. “The banks knew they were selling crap,” says a London-based trader from one of the bailed-out companies. To get AAA ratings, the CDOs relied not on their actual underlying assets but on crazy mathematical formulas that the banks cooked up to make the investments look safer than they really were. “They had some back room somewhere where a bunch of Indian guys who’d been doing nothing but math for God knows how many years would come up with some kind of model saying that this or that combination of debtors would only default once every 10,000 years,” says one young trader who sold CDOs for a major investment bank. “It was nuts.”

Whenever speculative bubbles burst, it’s interesting to watch what happens to the bullshit artists who were driving all the ridiculous transactions. Certainly the example discussed by Taibbi was egregious, particularly if the folks pushing that paper knew it was crap.

I saw some of this in 2000 with the Net bubble, and at that time, there were lots of young lawyers running around China talking up “deals” that they had in their pockets, often for investments in website-based enterprises, management of which had no clue about sustainable revenue. To be fair, these lawyers (and the investors they represented) thought that the deals were sound.

When the bubble burst, law firms quickly discovered that these guys had no real legal skills and cut them loose. At the time, it was fun challenging people like that on the business assumptions underlying the deals — most of these lawyers had no business background and, moreover, couldn’t care less about whether the enterprise made sense or not (they had faith in the magic of online enterprises). They were simply responding to a need of the market to allocate capital to these pieces of crap.

The bursting bubble this time centers on the financial services industry, and it’s much more difficult to ferret out just what kind of bad investments the hucksters were selling. Again, there has been a local analog to the more egregious practices that took place in London and New York.

What I saw locally that springs to mind is the formation of China funds, pools of capital set up to invest in the PRC market. The private equity funds were the most fun to deal with — some of these folks had no clue what they were doing, despite the fact that they were making recommendations on purchasing or taking large equity stakes in Chinese companies. Moreover, they often never considered exit strategies.

Keep in mind that a fund is just a big pile o money, that’s it. Once you start getting into the different types of funds, the myriad offshore structures and so forth, you are mostly talking about minimizing tax and liability. All of that is important, particularly for lawyers setting up the funds, but all of it is secondary to the fundamentals: it’s just a big pile of money.

China funds are set up to invest in China business. People working at those funds have a primary goal: find good projects and invest wisely. When bubbles are inflating, the definition of what is a “good project” and a “wise investment” becomes kind of dicey, and often what is the role of the investor post-purchase is murky at best.

Here’s a typical conversation with an inexperienced investment banker or consultant:

Me: So what are you planning to do in the China market?

Investment Banker: We’re setting up a dedicated fund for the energy market here.

M: I see. You’ve been involved in the energy market in other jurisdictions?

IB: Yeah, my boss used to be in Eastern Europe and handled some energy projects.

M: What about you?

IB: I just got out of business school last year.

M: Right. And you’re the number one guy on the ground here. If I may ask, how did you get this gig?

IB: I can speak Chinese.

M: Uh huh. So how were you planning on structuring these projects?

IB: As far as structure goes, we have a [insert flavor of the month LLC, partnership, etc. here] in [insert flavor of the month jurisdiction here].

M: No, I wasn’t talking about your offshore structure. I meant your onshore China structure. How are you planning to facilitate your investments?

IB: [stares blankly] We’re going to be investing in energy projects here.

M: Right. You going to acquire companies here or purchase equity of domestic companies?

IB: Maybe. I guess it depends on the project.

M: Of course. Have you had any discussions about how would hold that equity, which offshore entity would be used as an acquirer, or what your exit strategies might be?

IB: No, my job is to find and evaluate projects. Once we do some due diligence and green light a project, we instruct our lawyers about how the deal should be structured.

M: You get a legal opinion after you’ve decided to move forward with a project? Really?

IB: [getting annoyed] Of course. Look, no offense, but onshore structure is cookie cutter stuff. The real value added is getting these deals vetted. That’s what I’m doing. Once all that is done, we can get any lawyer to cross the ‘T’s and dot the ‘I’s.

M: Sure, I understand that, [sotto voce] asshole. So what would a typical target company look like for you?

IB: Lately I’ve been talking to a lot of energy production companies in Western cities.

M: Uh huh. Lots of upside out there.

IB: Absolutely.

M: Tell me, are these foreign companies, private Chinese companies, or public Chinese companies?

IB: They’re Chinese companies.

M: Yes. Public or private?

IB: I’m not sure. Some of them are probably State-owned, I guess. I actually have one potential target I’ve been working with for several months that is a State-owned company with several facilities.

M: Really? Interesting. How much time have you spent with these guys?

IB: Several visits, as well as some preliminary due diligence. These guys have amazing connections — I met with the Mayor and the local head of the Ministry of Commerce on my last visit. The project looks good at this point, although we have not done legal due diligence yet.

M: Talked structure yet?

IB: They are looking for at least USD 50 million.

M: Right, but how would that be structured?

IB: Probably our fund would be responsible for 35 million, with two other investors each putting in 15 million.

M: I see. What exactly are you getting for that 35 million?

IB: What do you mean?

M: You are investing in that company, correct?

IB: Yes.

M: And you will receive equity?

IB: I assume so.

M: Which corporate entity will be selling you this equity stake?

IB: I don’t know yet.

M: Is it a State-owned company?

IB: The parent company is.

M: Do you know anything about restrictions on the sale of State-owned assets or the complexities of restructuring State-owned companies?

IB: [annoyed again] I already told you that we are not at the legal due diligence phase of this deal yet. Once we get to that point, we can sort all of that out. You know, we rely on guys like you to help us through implementation issues. Maybe that’s a problem for you? I can always find another firm to help me — there are lots of lawyers who do this kind of work. It’s not rocket science.

I think you get the idea. The guy in the above example had limited experience in the energy sector, limited China experience, and probably only understood how to read a term sheet and a financial statement (one assumes).

Of course I am exaggerating a bit — dramatic license. There is a lot of truth to this, however, and despite the fact that there were a lot of talented, experienced folks making good deals, there were also a lot of stupid blowhards as well. Guys like that were sent to meet with Chinese companies that needed funding, and often neither side had any idea about foreign investment restrictions. Lots of money would be spent on financial due diligence and top-level business negotiations (including the usual meet-the-local-government-officials dog and pony show), and then these glorified salesmen, feeling like they had inside information on an amazing deal, would write positive reports back to HQ about what a great opportunity this was.

Sometimes an adult would then ask tough questions and the deal would be either restructured or scuttled. Sometimes it would then come to a law firm for an initial discussion about structure. Some of those discussions included phrases like “You can’t do it that way” or “This is going to take a lot of restructuring before this deal can go through.”

What’s my point? When you’re in a bubble and there is a lot of cash sloshing around, the usual rules are thrown out the window. During the Net boom, no one seemed to care about revenue, just how many hits your site got.

Over the past few years, investments were being made by folks who did not seem to care much about legal and business risk. A lot of convoluted pre-deal restructuring that took place on these transactions introduced a lot of risk that was not factored in. I think it will take years for many of these investments to unravel, and even in the short term, there will be some great work for Chinese litigators.

Here’s another example of how risk was dealt with differently by these folks. Five years ago, if you were a foreign widget company and you wanted to take a 50% stake in a Chinese widget factory, you went through the normal process of due diligence, you sent over your widget experts, and you talked to lawyers and accountants about how to set up a Joint Venture in the widget industry. Maybe the JV worked out, maybe it didn’t, but it was a straightforward transaction, and the players knew what they were doing for the most part.

Over the past few years, as China became a red-hot market, everyone wanted to get in on the game. Throw some money together and get some folks to buy Chinese companies. Sounds like a good idea. But some of those people working for these funds (PE in particular) had little industry-specific experience and no idea about some of the legal hurdles involved. I don’t blame them for the latter, but it did piss me off to no end when they belittled the contribution of lawyers and only got us involved after they pissed away hundreds of thousands of dollars evaluating projects that were structurally impossible to begin with.

I started off with Matt Taibbi and the talk about CDOs and other bullshit. These China investments were not in the same league, and most of these deals were legitimate and, I assume, reasonable investments. But as the money pot grew, the more bullshit was thrown around by target companies and consultants, and a lot of these guys were simply out of their league.

Now that the money has dried up, I assume that a lot of the snake oil salesmen and novice China investors are no longer in positions of authority. Hopefully the people remaining are much more conservative and experienced, and the deals they are pushing are more thoroughly vetted.

At least until the next bubble is upon us.

Tags: China Business & Economy, china funds, foreign direct investment, private equity

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Full post as published by China Hearsay on March 28, 2009 (boomark / email).