In recent years, many mediocre companies and short-lived commercial myths have been the target of round after round of investment by foreign parties. Bad projects fetched skyrocketing prices as China's red-hot VC/PE market blew big bubbles.
Looking deeper, it is not difficult to see that one of the main culprits is the "fool-you" culture of this industry. For example, some general partners (GP) of foreign PE funds abandon the primary goal of finding good projects to get high returns and don't wait until the end of their investment tenure to cash in their bonuses. Instead, they have tried their best to legally take money out of the pockets of foreign investors and then change jobs. The final victims are invariably the limited partners of these foreign funds, who have to write off the investment losses.
Guinea Pigs are collected as pets because of their cuteness and resemblance to baby pigs. But the difference is that Guinea Pigs will never grow big and fat like real pigs. Similarly, investors in "Guinea Pig" projects can never expect the promised high growth and return.
VC/PE expert Chen Ming said international PE investments were good projects in China before 2006 because of a general lack of attention in the country to this relatively new industry. When the bull market started in 2006, these projects excited investors with tens or even hundreds of times return. That attracted an influx of foreign capital into China's PE market. But it also changed the whole environment of the market.
As PE investment became hot, investment bankers switched jobs to join PE teams. The Wall Street professionals brought with them a different culture. They tried everything to maximize short-term gains while overlooking the fundamentals. As a result, according to Chen, such projects became "Guinea Pigs".
"First, the micro-economic situation worsened. On top of that there was a flood of new foreign money. Everything was simplified. You often saw 10 people managing a $10 billion fund. And the investment pressure drove them into impulsive decisions", Chen said. "Another easy thing they did was to follow others' suites. That explains why a relatively good-looking project crowded five or six foreign funds."
In addition, an overflow of capital gave target companies a strong bargaining position. Price was therefore doubled and due diligence went out the window. Risks were greatly increased.
If "Guinea Pig" projects are at least still alive, "dead pigs" projects exposed the managers who really crossed the line in playing with foreign investors’ money.
"Fool-you" refers to a kind of pyramid scam in the industry. First, a project company fools initial investors into investing in its company. Then they jointly fool lateral investors into further investment. Finally they come together to package the project for IPO and pass all the risks to individual investors.
The best example of this is ITAT Company, which boasted a unique business model of allying textile producers on the one hand and commercial real estate on the other with ITAT in the middle. In practice this model has no competitive edge: Products and brands are not tailored to the consumers' tastes. Commercial real estate is not stable and offers no added value.
The revenue sharing scheme cannot guarantee continued operation. "The flaws of this model were so apparent that even the underwriters could easily find out," a local PE manager said. "But those several foreign funds still poured money into this company. Don't say these PE investment managers could not see the potential problems. That will make me laugh."
However, Blue Ridge China, famous for its aggressive approach, made an initial investment of $50 million in ITAT at the end of 2006. In March 2007, Blue Ridge, Morgan Stanley and Citadel together invested another $70 million. In total, Blue Ridge China has invested $80 million in ITAT. There were no doubts about the defects of ITAT's commercial model. But the fund managers only cared about a successful IPO. So long as they can pass the risks to individual investors, anything would do. In the end, the Hong Kong Stock Exchange did not approve this IPO. The whole operation proceeded to fall apart. Underwriters withdrew, accounting firms stopped working... all thanks to the Hong Kong Stock Exchange.
If the $80 million goes down the drain, how can Blue Ridge China explain things to its investors? After all, those who were actually victimized are the investors or the limited partners (LP) of the Blue Ridge China and Morgan Stanley funds. The fund managers were gambling with the money of those investors. "They package 'dead pigs' as good fat pigs to sell to new investors. When new investors found out the truth, they had no other way out but to join the initial investors to continue telling the lies to get more investors, like a pyramid scam, until the bubble bursts," Chen said.
A Chain of Grey Interests
The manager at a famous foreign fund says 70 percent of its projects come from "middlemen", or individuals rather than institutions. Why do these GPs need so many such "middlemen"?
One local fund manager explained: "If I follow up a project and it is nearly ready, I would tell my investment committee that this project was introduced to me by another manager who works for another fund. I would get a finder's fee, which I will share with the other manager. The other manager will do the same to me with his projects. We both have legitimate income."
To prevent such practices, some foreign funds prohibited a "finder's fee" or "introduction fee". That proved little problem for the greedy GPs. "The fees can be paid by the target company to a related person designated by the GP. This is allowed and has no direct link with the fund," the manager said. "But the fund has to pay for it one way or another. Also, in some cases, an investment fund can buy out a company at four times P/E. But the GP talked the fund into paying five times P/E. The extra amount will be shared between the target company and the GP." In this chain of grey interests, there is inevitably the real "intermediary", the investment banks. With their expertise in packaging the projects, investment banks added a formidable force in pushing a quick investment decision by the funds.
One's Own Fund Is a Better Place to Earn Money Than a Good Project
If cheating funds with a "finder's fee" is a practice limited to a few managers, the most commonplace practice to rip off investment funds is to invest as much as possible within the provided time frame and skip the necessary project investigation and review work and the hard bargaining of purchase price.
The international practice for VC/PE is that the management fee is calculated on the actual paid-up amount of the fund. And fund investors normally only pay a fraction of the committed amount at the formation of the fund. The rest will be paid up when there are enough project reserves. In other words, when there are no projects, there is no paid-up capital and no management fee. One fund manager said, "so long as the projects' information is open and transparent and the due diligence is in compliance with the required formula, we can then call the money from investors and invest it out. As to the long term prospect of the project, good or bad, it all depends where you stand. The interest of the investors and the fund managers may not always be the same."
From this standpoint, it is easy to understand the presence of so many bad investment projects. If you raised a $1 billion fund, invest it as soon as possible. That means you can earn a $20 million management fee. Whether the projects can generate the expected return years later, many GPs do not care. To them a brand-name foreign fund can only be a temporary shelter. Before the boat sinks they can always jump. That is why so many people in this industry change their jobs so often.
Fifty-one new China investment funds were formed in 2008, including $30-denominated funds with a total amount of $39.49 billion, amounting to 64.6 percent of the total funds. That means foreign PE funds will still be the major player in this market.