International Law

China FDI History Repeats Itself

By Stan

You may recall a recent post of mine about Venture Capital and Private Equity, wherein I pointed out, among other things, that the preferred investment structures have been a bit more risky than you might think.

I also drew a comparison between the standard Joint Venture problems we see in China and the disputes between VC/PE investors and the Chinese enterprises in which they have put their cash.

Proving once again that there are indeed some major common themes with the China foreign direct investment market, take a look at this article from the China Economic Review on FDI in the real estate sector:

Foreign banks and hedge funds flocked around Chinese real estate developers when the market was hot for both property in general (so potential valuations were high) and IPOs in particular (so investors had a way of realizing the stellar profits arising from these high valuations).

Now the property market is down and the IPO market is moribund. The developers used the funds supplied by the banks and hedge funds to expand their business, which left them with a stack of units they can?t shift and a stack of debts they can?t pay off. Meanwhile, the banks and hedge funds face balance sheet pressure back home, but can?t exit their investments.

Well, that already sounds familiar. Looks like all those Net investments from nine years ago. Everyone was going to have an IPO within three years, and some of those schmucks bought into the hype and threw in their tens of millions.

But wait, it gets better. Not only were these real estate investments made with a bubble mentality like with the Net companies, but they also used a lot of the same high-risk investment structures. This is textbook, or maybe I should call it classic, China FDI structure in a restricted industry:

[T]he banks and hedge funds entered into these pre-IPO deals through offshore vehicles. They lent money outside of China to the property developers? own offshore vehicles, which were set up as part of the international listing process. These loans were ultimately secured against the property developers? assets inside China ? but offshore creditor rights are not enforceable in Chinese courts. Resolving this through offshore courts is possible but time-consuming. As a result, foreign investors find themselves at the back of the queue when it comes to divvying up whatever valuable assets remain on the developers? books (assuming this happens at all, given Chinese banks? well-known reluctance to foreclose). The onshore-offshore disconnect effectively puts more power in the hands of Chinese companies in terms of negotiating settlements.

D’oh! You know, it surprised and shocked me during the Net boom to see high-traffic China portals listing on NASDAQ. I asked folks at the time how that was possible, seeing that these were Chinese companies, their operations were in China, all their people were in China, and the industry was restricted.

No problem, I was told. These companies weren’t listing their China assets, just their offshore assets. Moreover, there were these wonderful long-term service agreements between the offshore companies and the China operations, so the listed entity was really the one sucking out the big profits (not that there were any profits, or even revenues, back then). Enforceability of those service agreements? Stop asking those tough questions!

So how did these companies pass muster during the U.S. listing process, and why would anyone buy shares in one of those companies when they had serious risk built into their legal structures? Again, this is the finance sector, and everyone involved is a lot smarter than me, so whenever I asked those questions, I got condescending/pitying looks. That poor guy just doesn’t know what life is like in the big leagues. The answer of course is that quite a few people in the industry knew it was all bullshit, but since people wanted to buy into China Net companies, everyone let the truth slide — these companies had no significant offshore assets, it was all a fiction. Apparently a lot of mutual fund managers do not read disclosure statements all that closely, or maybe just don’t care about legal risk.

Seems like the real estate bubbleheads didn’t swap notes with their Internet bubblehead counterparts. Maybe it wouldn’t have done much good anyway — a lot of the Net investments made by the VC/PE guys over the last few years utilized the same sort of structures, so obviously they haven’t really learned their lessons too well either.

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Full post as published by China Hearsay on April 09, 2009 (boomark / email).