China's governance challenge

Chinese companies are gradually waking up to Western standards of corporate governance, but there is much progress still to be made - and investors must tread carefully. By Andy Thomson

David Mahon, a New Zealander who has been investing in China since 1985 through his Beijing-based private equity firm Mahon China Investment Management, has seen great change in the business environment there. ?In the last 25 years of economic reform in China, corporate governance has improved markedly, he says.

But Mahon adds an important caveat: ?Transparency is still a long way off and you can't take anything for granted with either listed or unlisted firms. Foreign investors and analysts need to look carefully at each company.

The improvements noted by Mahon have much to do with the need to attract foreign investment. For a private Chinese company, a willingness to adopt better corporate governance procedures can make all the difference when seeking to secure an equity commitment or when attempting to list on a stock market. For state-owned enterprises, a preparedness to be open and reveal all the skeletons in the cupboard could be enough to persuade Western banks and buyout firms to commit to a deal.

But observers of the market say that while the Chinese government is keen to push through corporate governance reforms, only limited success has been achieved thus far.

China's advances in corporate governance, or lack thereof, are being followed closely by Western-based private equity firms, many of which are eager to establish toeholds in the country but worried about the ability to effectively guide portfolio companies. ?There is a distinct trend at both the central and provincial level to improve standards and accountability, says Mahon. ?But it's a much decentralized country. So what Beijing intends to happen and the degree of obedience to that intention is relative to distance from Beijing.?

Simon Little wood, CEO of London Asia, a London-based firm that advises and invests in Chinese companies pre-IPO, agrees that geography is a factor in the appliance of good corporate governance, but warns that the rest of China is not like Shanghai: ?Corporate governance is about more than just ticking a box, it's about understanding why the rules are there – and that depends a lot on where companies are based. In Shanghai, it's more advanced and there is an understanding of all things international. If you go somewhere that has not had as much exposure to the West, corporate governance is not as advanced.?

Little wood maintains that perhaps the biggest corporate governance issue in China is a failure to disclose certain actions undertaken by senior management. Sometimes these actions can be significant to say the least:he cites the example of the CEO who has completed a major deal and not disclosed it to the rest of the board or the shareholders. Other common weaknesses include the misuse of assets and a lack of adequate accounting systems.

Albert McLelland, senior managing director of advisory firm AmPAC Strategic Capital, lists what he sees as the key corporate governance weaknesses in Chinese companies in the box at left. The listis extensive because, he says, corporate governance is a new concept in the country. However, he suggests that ?if you are bringing capital to the table then you'll find there's much more of a willingness to open up to you and that by incentivizing management teams appropriately you will stand a much greater chance of ?finding where the bodies are buried.?

Rather than viewing lapses in professional standards as a negative, many investors see opportunity in the lack of sophistication. Mahon says improvements in performance can be extracted from implementing best practices and decent financial management in target companies. Little wood adds that London Asia always seeks board seats so the management team can be guided from close quarters in the early stages of the investment. As the firm gets closer to IPO, London Asia will take a step back while continuing to ratchet up corporate governance standards by bringing in experienced industrial executives.

When introducing outside influence to a Chinese company, though, it is best to tread carefully. Unquoted businesses are frequently run by single-minded entrepreneurs who would feel insecure in the face of any perceived threat to their control over the firm. In public companies, meanwhile, there is frequently a ?traditional hierarchy, says Mahon, with decisions made by only a few people. ?As an investor, you've got to look carefully at these situations, he cautions, ?and you need to ask yourself whether you can challenge the existing fiefdom.?

But an ability to challenge the status quo can be vitally important, particularly when it comes to listing Chinese companies and meeting the frequently challenging corporate governance standards of international stock markets. Regulatory demands in Hong Kong, Singapore and the US – whose stock markets account for the majority of Chinese listings – are stringent.

Interestingly, this appears to have created an opportunity for the UK's less highly regulated Alternative Investment Market (AIM), which by mid-September 2005 had seen 12 listings of Chinese companies, including EBT Mobile China, a retailer of mobile phones and services with operations around Shanghai. AIM was set up ten years ago by the London Stock Exchange, with the intent of providing a lightly regulated home for small companies.

Interestingly, this appears to have created an opportunity for the UK's less highly regulated Alternative Investment Market (AIM), which by mid-September 2005 had seen 12 listings of Chinese companies, including EBT Mobile China, a retailer of mobile phones and services with operations around Shanghai. AIM was set up ten years ago by the London Stock Exchange, with the intent of providing a lightly regulated home for small companies.

Says Mahon:?You need to write contracts that will give you real control if it's needed and that will allow you to appoint senior management and give you control of financial arrangements – possibly even control of such things as purchasing, sales and banking. The good news is that, once such measures are put in place, they are rarely regretted – by either party. ?Chinese management tend to realise the benefits very quickly, concludes Mahon.

Crouching conflicts, hidden dangers
Chinese companies typically have many pitfalls lying in wait for the unwary investor. Below are listed some of the most lethal hidden dangers:

Property rights: frequently not properly reflected in deal documentation

Labor and welfare rights: the treatment of labor and retrenchment issues are often unclear. Wages, pension and social insurance may be overdue

Lack of separation of government and management functions: government interference, connivance of local government in hiding assets and a misrepresentation of liabilities

Liabilities (especially contingent and non-balance sheet liabilities): these may not be reflected in the balance sheets, debts owed to employees, etc

Associate companies: these may not be properly accounted for in the company's records. Investors in China frequently come across the practice of so-called ?leasing of a whole branch office or department to be operated by the ?lessee with independent accounting. Or, the reverse of this where associate companies sometimes default the parent by setting up a new company to lease the assets of the ?old company and employ most of the employees – leaving the old associate company to carry the debts with few employees and obsolete equipment

Taxes: unpaid taxes or hidden tax liabilities are commonplace

Bank accounts: Chinese corporations are allowed one Class A bank account (without restrictions) but may have more than one secondary account (restricted – cannot withdraw cash but otherwise the same), project account (accounts opened for specific projects), and loan account (accounts opened for specific loans).

Scary story
In the Autumn 2005 edition of its China Watchnewsletter, Beijing-based private equity firm Mahon China Investment Management relates the case of an unidentified European communications technology manufacturer and its purchase of a Chinese firm that was able to ?produce many labor-intensive parts at one-fifth of the production price in either Europe or the US. The deal was overseen by a young, Beijing-based representative who insisted that it would have to be concluded within two weeks:meaning there was no time to engage outside due diligence advisers.

China Watch takes up the story of a deal done in haste and regretted at leisure – providing many lessons about corporate governance weaknesses and the need for thorough and expert due diligence:

The representative had never evaluated an actual company before, nor had he negotiated and closed a deal. The European managers assumed that if they only addressed the ?Chinese? issues of the company – issues related to culture and relationships – the normal commercial requirements would follow.

A dispassionate glance at the report on the Chinese company prepared by their representative would have alerted any business person to the problems.

The representative assessed the current margins of the Chinese company as 50 percent and assumed this would not change within three years. Yet this market was among the hottest in the Chinese economy, and competition was increasing by the quarter. Pressure on margin in the industry was already evident.

The CEO and majority shareholder of the Chinese company gave the representative much of the financial information verbally. He insisted that any breakdown of sales costs was difficult as so much took place under the table. Nevertheless, the representative constructed an impressive report with many complex financial nuances.

?We are in a sensitive relationship with a leading entrepreneur. If we question these numbers too much we will lose his trust,? he told his European bosses.

In his report, he mentioned debts but failed to account for the cost of servicing them. Dividends had been declared over the previous two years, but never distributed. The Chinese company also had an arrangement with the local tax authorities to pay less than 40 percent of the normal requirement. Receivables were half of the annual sales value, yet management could not present any aging analysis on them. Real cash flows in the business were therefore questionable.

Most senior managers were related to the CEO and majority shareholder. The majority shareholder also owned an identical company in the city of Tianjin, to the south, which was not included in the deal.

The European company had agreed that the incumbent Chinese managers would all stay in place after the transaction, although all the money that the Europeans were anticipating paying for the company, US$12 million, would go to these managers, who were also shareholders. The Europeans did not attempt to stage payments to the Chinese shareholders that were conditional upon the company reaching performance goals.

Nor, following the acquisition of 80 percent of the shares by the European firm, were there provisions to put any working capital into the company or to govern the multi-millionaires that they were about to create in the incumbent management team.

The Chinese owner insisted that in the worst case scenario the land on which the business was situated alone justified the deal. The inevitable increase in the value of the RMB against both the Euro and the US Dollar, the representative asserted, supported the future value, and in itself justified the deal.

The European company made its investment. It found that the sales were less than half of those stated by the company. They also found that the cost of sales was astronomical, for much depended on the local sales force bribing the buyers working for their customers to take their product. The Chinese company's debts were to local firms, who insisted that the company, within days of the completion of the transaction, repay them. The payables were legion. Some suppliers spent days in the company's boardroom arguing loudly with management.

The now desperate Chinese managers explained to their workforce and their suppliers that all these problems were due to the foreign partner who now owned 80 percent of the company. A delegation from Europe arrived a month after the deal had been signed and were literally besieged in the factory. The workers went on strike. The young representative was persuaded to come back from Beijing in order to help. He made one call to the city government and beat a hasty retreat.

The vice mayor of the town arrived and told the Europeans that he would try to help. First, however, there was the issue of the company's unpaid taxes going back three years prior to the transaction. These, he said, must be paid as soon as possible. He insisted that the Europeans must also put more cash into the business to placate the suppliers, workers and clients. Without such an investment, the city's banks would cancel all working capital facilities.

Incidentally, they added, the land on which the factory stood had been mortgaged or used as third party loan guarantees by its previous owners to the point that it was worth very little. It was under the terms of the original lease, anyway, nontransferable.

The European managers continue their negotiations. The former Chinese CEO and majority shareholder has resigned and now runs a company making similar products in Tianjin.