Guanxi: tales of investments in China



At 7 pm on Friday 6 May, a good looking stewardess of Olympic Air, offered me the last copy of the Financial Times on board the flight from Bucharest to Athens. I could not help but notice on the front page of the second section a story about Carlyle’s investments in two Chinese companies. The next day I searched the story and thanks to John Hempton I found the key word: Guanxi. Connections the Chinese way. The network of contacts prevails in making the “right deal”. After the necessary definition, courtesy of Wikipedia, I present the protagonists using already published material, and proceed with the story as it unfolded in the media. The conclusions, if any, are yours. For the record, I present mine.


At its most basic, guanxi describes a personal connection between two people in which one is able to prevail upon another to perform a favor or service, or be prevailed upon. The two people need not be of equal social status. Guanxi can also be used to describe a network of contacts, which an individual can call upon when something needs to be done, and through which he or she can exert influence on behalf of another. In addition, guanxi can describe a state of general understanding between two people: “he/she is aware of my wants/needs and will take them into account when deciding her/his course of future actions which concern or could concern me without any specific discussion or request”

(Source: Wikipedia)

The Protagonists

Carlyle Group

The Carlyle Group is an investment firm specializing in direct and fund of fund investments. Within direct investments, it specializes in management-led buyouts, strategic minority equity investments, equity private placements, consolidations and buildups, leveraged finance, and venture and growth capital financings. The firm typically invests in agriculture, aerospace, defense, automotive, consumer, retail, industrial, infrastructure, energy, power, healthcare, technology, real estate, financial services, transportation, business services, telecommunications, and media sectors.

William Conway Jr

The firm originates, structures, and acts as lead equity investor in the transactions. The Carlyle Group was founded in 1987 and is based in Washington, District of Columbia with additional offices across North America, Latin America, Asia, Africa, and Europe.

(Source: Business Week)

It is hard to imagine an address closer to the heart of American power. The offices of the Carlyle Group are on Pennsylvania Avenue in Washington DC, midway between the White House and the Capitol building, and within a stone’s throw of the headquarters of the FBI and numerous government departments. The address reflects Carlyle’s position at the very centre of the Washington establishment, but amid the frenetic politicking that has occupied the higher reaches of that world in recent weeks, few have paid it much attention. Elsewhere, few have even heard of it.

David Rubenstein

This is exactly the way Carlyle likes it. For 14 years now, with almost no publicity, the company has been signing up an impressive list of former politicians – including the first President Bush and his secretary of state, James Baker; John Major; one-time World Bank treasurer Afsaneh Masheyekhi and several south-east Asian powerbrokers – and using their contacts and influence to promote the group. Among the companies Carlyle owns are those which make equipment, vehicles and munitions for the US military, and its celebrity employees have long served an ingenious dual purpose, helping encourage investments from the very wealthy while also smoothing the path for Carlyle’s defence firms.

Daniel D' Aniello

But since the start of the “war on terrorism”, the firm – unofficially valued at $3.5bn – has taken on an added significance. Carlyle has become the thread which indirectly links American military policy in Afghanistan to the personal financial fortunes of its celebrity employees, not least the current president’s father. And, until earlier this month, Carlyle provided another curious link to the Afghan crisis: among the firm’s multi-million-dollar investors were members of the family of Osama bin Laden.

(Source: Oliver Burkeman and Julian Borger, 31 October 2001, The Guardian)

China Forestry

China Forestry, which is 10.96 percent owned by Carlyle, operates plantation forests and supplies timber to the construction, furniture, interior decoration, wood product and paper industries in China. (Source: REUTERS)

Carlyle first bought a stake of about 12.5% in China Forestry for around US$40 million in 2008, according to the company’s listing prospectus. In June 2009, Carlyle bought an additional stake of nearly 4% in China Forestry for about US$15 million, the prospectus said. Also in June 2009, another private-equity firm, Partners Group, bought a 7% stake in China Forestry for US$30 million.

Carlyle’s stake in China Forestry now is around 11%, while Partner’s stake is 5.51%, according to the Hong Kong stock exchange. Carlyle’s stake is valued at roughly US$127 million.

(Source: Isabella Steger, 9 February 2011, Wall Street Journal)

China Agritech

China Agritech, Inc. is engaged in the development, manufacture and distribution of liquid and granular organic compound fertilizers and related products in China. The Company has developed proprietary formulas that provide a continuous supply of high-quality agricultural products while maintaining soil fertility. The Company sells its products to farmers located in 28 provinces of China.

(Source: the company’s website)

‘Backdoor Registrations’

In a reverse merger, a closely held corporation buys a publicly traded shell company and retains its U.S. listing. China Agritech came into being after China Tailong Holdings Co., a fertilizer maker founded in 1993 by Yu Chang, merged in 2005 with Basic Empire Corp., a shell company that began life in Nevada in 1925 as Argyle Mining Co. and no longer had any business operations, according to a China Agritech filing.

Companies that get listings on U.S. markets by reverse mergers aren’t subject to the same scrutiny as those that make initial public offerings, Luis Aguilar, a commissioner at the U.S. Securities and Exchange Commission, said in an April 4 speech. More than 600 such “backdoor registrations” have been done since 2007, including about 150 by firms based in China, and a “growing number” of those companies “are proving to have significant accounting deficiencies,” he said.

(Source: James Sterngold,  Bloomberg, 27 April 2011)

Financial blog ZeroHedge just posted a research report by LM Research claiming fraud in the company of China Agritech Inc (CAGC).

According to the report, China Agritech, a co. that manufactures and sells organic liquid compound fertilizers and related agricultural products in the People’s Republic of China, “is not a currently functioning business that is manufacturing products”. Instead it is, in LM R’s view, “a simple vehicle for transferring shareholder wealth from outside investors into the pockets of the founders and inside management.”

LM Research has set a $2 price target on CAGC shares based on the co.’s cash books – $45.8M – divided by – 20.77M – the number of outstanding shares. LM R also notes in its analysis that since the company has no valuable technology, intellectual property, or capital assets, “there is no value to it other than dissolution value“.

(Source: Ron Haruni, 3 February 2011, Wall Street Pit)

The Story

In earnings released Friday (29 April 2011), China Forestry reported a loss for 2010 of 2.71 billion yuan after drastically lowering the value of its plantation holdings, the company’s chief asset. The company said it couldn’t ensure that its financial statements were accurate, though, because, among other things, “most of the former key accounting personnel have left without notice.”

The Hong Kong Stock Exchange

Before China Forestry’s shares were suspended, both Carlyle and Partners Group had made money on their investments, which are small in comparison with their outlays in more developed markets. They could still end up winners if the company recovers from its troubles.

The extent of China Forestry’s problems, nonetheless, underscores the risk that potential fraud and poor corporate governance pose for private-equity and other investors in emerging markets, where regulatory and other standards often don’t match those of developed markets.

“There are an increasing number of transactions in China, where it can be difficult to assess businesses,” said Scott Jalowayski, a lawyer at Ropes & Gray LLP in Hong Kong. “Even careful and disciplined investors can run into problems with deals,” he said, adding that private-equity firms can sometimes turn around poor investments and make them successful.

In addition, private-equity companies are often under pressure to deploy funds even when there is a dearth of good deals, industry observers say.

Michael Cheung, vice president at China Forestry, said in a statement that the company is making a number of changes, including the adoption of enhanced, centralized financial reporting and the hiring of new management to oversee the process.

Chairman Li Kwok Cheong “is determined to step up internal control to improve the management of the company to take advantage of the growing opportunities in the market,” Mr. Cheung wrote.

An investigation by an independent board committee found that China Forestry’s former management team provided its auditor with false bank statements, inconsistent insurance-policy documentation and falsified logging permits for about 100,000 cubic meters of wood. Most of the group’s sales from 2010 were conducted in cash, the committee said, and Mr. Li, the former CEO, kept more than one set of books, so that “actual cash movement was concealed from the board.”

“The big unanswered question is: was the cash there and stolen, or was it never there in the first place,” said hedge-fund manager and financial commentator John Hempton. “One implies fraud from inception and no real business, and the other implies a real business that was run by people who stole from it,” said Mr. Hempton.

He said he holds positions in more than a dozen Chinese companies he believes are involved in fraud but wouldn’t disclose individual positions.

Another question involves regulation—whether China Forestry, whose initial public offering was underwritten by Standard Chartered PLC’s Cazenove Asia Ltd. and UBS AG, should have been allowed to list. Hong Kong’s regulators have complained about poor work done by certain banks and other financial sponsors in screening companies that come to market.

David Webb, a shareholder activist, said that some of the blame must rest with the regulators themselves.

“It remains unclear whether the alleged fraud was going on at the IPO stage, but so long as prospectus liability law in Hong Kong remains as weak as it is, there isn’t much incentive to do the sponsorship and auditing job any better,” he said.

(Source: Kate O’Keeffe, Isabella Steger, 5th May 2011, Wall Street Journal)

The first thing to note about the company is that it’s a Chinese natural-resources company at a time when natural resources are a hot investment story in China. And surely even the worst-run timber company ought in theory to be positioned to capitalize at least a little bit on China’s construction boom.

One might then notice the matter of land valuation. Skeptics of China Forestry’s IPO have noted its statement that its profits in the three years leading up to its offering arose almost exclusively from the appreciation of its forest-land holdings rather than from operations. That would raise questions for an investor looking to put money in a forestry company. But to others it would represent a useful form of acumen.

Consider China Forestry’s success so far in obtaining land at “favorably low” prices. While the company warned that this might not continue indefinitely—quoth the prospectus, “sellers may become increasingly sophisticated about the valuation and prices of their forests and may demand higher premiums for high quality forests”—that loss of advantage isn’t necessarily inevitable or imminent.

One of the company’s not-so-secret weapons is its chairman, Li Kwok Cheong, who boasts a spot on the council of the China Council for the Promotion of Environment and Forestry, a nonprofit group managed by the State Forestry Administration. China Forestry Holdings trumpeted that connection in its prospectus: “We are better able to obtain, easily and quickly, the first-hand information on the latest development of the forestry industry in China. We identified suitable forests for acquisition based on the information we obtained from the forestry industry.”

In sum, investors were presented with a company possessing demonstrated skill at amassing a potentially valuable asset owing to its apparent good connections to the government and other industry insiders. Reading between the lines, such connections could also help in securing the logging permits the company would need on an ongoing basis to conduct what is supposed to its core business. And to top it all off, this is in a sector Beijing has singled out for development, meaning lower corporate taxes.

Maybe China Forestry’s novel business model would work, and maybe not. Maybe it would overcome its relative inexperience, and maybe not. Maybe the company would find a way to achieve operating profits, and maybe not. That kind of business question seems less relevant when you’re interested more in investing in companies based on their ability to work the Chinese system. Hong Kong investors have made that kind of bet before, as in the mid-1990s when the hot gamble was that Beijing would inject state assets into large companies.

Fraud is fraud, and if investigators discover shenanigans at China Forestry Holdings, Hong Kong’s regulators and courts will offer some recourse to deceived investors. But temper the outrage that China Forestry was allowed to list at all. While some or even many might have considered it a “bad” company, it was not necessarily a bad investment as Chinese investments go. The question is not whether something has gone wrong with Hong Kong’s listing standards. The question is what is going wrong with China such that investors are betting on something other than the quality of an entrepreneur’s ideas.

(Source: Joseph Sternberg, 17 February 2011, Wall Street Journal)

“To this end I present to you China Forestry.  China Forestry was a billion USD Hong Kong listed Chinese company with many Private Equity funds having stakes.  The leading stakeholder is Carlyle (or more precisely funds belonging to Carlyle’s clients).  The stock has been suspended after admitting “accounting irregularities”.  But it is worse than that.

China Forestry had a business model which consisted of fast-growth forestry to extract greenhouse gas credits – a business model that barely made sense to some analyst guys that looked at it.  However it was a business model that made sense if the company had enough Guanxi – enough connections to extract a really bad (ie nonsensical) deal from the Chinese government.  And the holders of China Forestry to some degree believed just that.  They believed in the Chinese Guanxi.  And implicitly they believed the deals were being bought to them by the Guanxi of their staff.

Now China Forestry remains suspended.  No reasonable questions are being answered – so I am going to reveal to you the Analyst gossip: the bulk of the forests do not exist.  Sure they had some “front” – plantations they would take potential investors to.  But the vast bulk of the business was a fiction and “accounting irregularities” is code for “fiction”.

Oh – and Carlyle has dusted 105 million dollars.

If this is fraud then Carlyle has a little egg on their face.  After all – what is the point of having all those investment professionals if they get dusted by the simplest of frauds.  The whole point of private equity is that by pooling capital you can get insider positions and you can run the company for cash – for the benefit of your investors.  But if your “insider position” doesn’t even allow you to spot the business does not exist then your insider status is worthless.  You might as well close up and go home.  You have no right to be in business.

This blog has been detailing another stuff-up of Carlyle.  I am short China Agritech – a company listed on the NASDAQ with operations in China.  At least the operations are meant to be in China but after considerable looking (only part of which has been detailed on this blog) we cannot find any convincing evidence that the bulk of the operations exist.  In this case Carlyle is the biggest investor and has exercised its right to appoint a board member.  Again it looks like they have been dusted.”

(Source: John Hempton, Bronte Capital). Read more:

My Conclusion

Was Carlyle unlucky? I do not think so.

They look like they placed too much trust on advice they received and forgot the fundamentals of investing in value creation, rather than something that looks nice and people say it is.

It sounds very very basic for a mistake to be made by investors at this level, but I prefer this to another explanation.


    • Καλημερα αγαπητωτατε μπιζνες αναλυστ. Ενα αρθρο σε μια εφημεριδα εγινε αφορμη για ολη αυτη τη μελετη. Αυτο το “Γουανζι” (ειμαι σιγουρη οτι ετσι προφερεται, μου θυμιζει κατι κλειστα κλαμπ που δημιουργηθηκαν πριν δυο αιωνες στην Ευρωπη και στην Αμερικη και που τα μελη τους ενεργουσαν συμφωνα με το “το να χερι νιβει τ’αλλο και τα δυο το προσωπο.” Δεν αναφερω ονοματα αλλα προσωπικα τα απορριπτω. Περα απο το σημερινο σας αρθρο, κι επειδη τωρα τελευταια με την οικονομικη κριση προσεχουμε περισσοτερο, ειναι να τρελλαινεσαι με το ποσο ευκολα κερδιζονται η χανονται περιουσιες πισω απο μια κλειστη πορτα.
      Να μια αναρτηση που αξιζει να την μοιραστω με αλλους. Σας ασπαζομαι.

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