China regulators can obstruct PE practices

Laws in China can hinder firms trying to make operational changes or detect fraud in private equity portfolio companies, although this could be changing, according to industry specialists.

Making significant operational changes in Chinese companies can be difficult when complying with extensive regulations, according to Ivo Naumann, managing director at consultancy firm AlixPartners, speaking at a media briefing in Hong Kong last week. 

For example, China is a difficult place to do mass layoffs due to the strict labor laws in place, which many people underestimate. “There is no chance of doing a mass layoff in China unless the labor bureau and local commerce bureau is involved from very early on,” Naumann said.  

He added that any layoff involving 20 or more people requires approval from local government, who will likely make the firm stagger the dismissals. 

There is no chance of doing a mass layoff in China unless the labour bureau and local commerce bureau is involved from very early

Streamlining businesses can be fundamental to making operational changes in private equity investments, in particular in cost-cutting or making businesses more efficient. 

One private equity-backed Asian consumer business was advised by AlixPartners to reduce its headcount by 40 percent in its first year of restructuring, with remaining employees asked to take a salary reduction of a combined $5 million across the board, the firm revealed in a case study. Further headcount reduction was planned for the following year.

Sean Zeng, president of Tower China that had gone through a restructuring with AlixPartners, which included a headcount reduction from 2,000 people to 1,300, said the government in China is becoming more amenable to these aggressive measures by not obstructing foreign professional firms from making operational changes. Formerly, the Chinese government had restricted the market by taking on restructurings itself, not allowing external firms to carry out this type of work in China.

He said although it can be difficult, cuts can be justified, adding, “do you want keep the 20, 30, 40 percent [of employees] and bring the company down, or cut the excessive workforce?” 

Similarly, China’s state secrecy laws have been obstructive when consultants are called in by private equity firms to identify fraud, as the firm may not have access to all necessary documents, Chris Fordham, managing partner of fraud investigation and dispute services at Ernst & Young, told Private Equity International. 

The inability to obtain credible financial information can particularly hinder restructurings or turnaround deals as finding out about a fraud half-way through can kill a restructuring, according to Rob Morris, managing director at AlixPartners. He said it is “far more damaging” to find out about fraud three to six months into a restructuring than knowing fraud exists when entering the situation.

But China is cracking down on corruption and has taken visible steps to do so, E&Y’s Fordham believes. For example, during 2012 the Chinese government brought in a regulation similar to the US Foreign Corrupt Practices Act, which prosecutes those taking part in fraudulent activities. However, Fordham says the real difference is in the enforcement of these laws, rather than their existence.