Investing in China

Phil Groves, DAC Founding Partner

DAC is a privately held investment manager and advisor focused on special situation investments with an absolute return objective. DAC sources, values, and manages Asian investments including single and multi-credit non-performing loans, distressed real estate, and distressed equity and structured financings. The firm was founded in 2002 and currently manages more than $400 million (US) across two funds (22 investments), several separate accounts and numerous investment-specific engagements across five countries in Asia. It is considered to be the largest buyer of mainland non-performing loans, having bought more than 45,000 soured loans from mainland China lenders since its founding. Phil Groves, DAC’s founding partner, shares his insight on DAC and the overall investment state of China.

What is the State of China’s Economy?

Is it headed for a major correction? Eventually yes, but not for the next couple of years, due to the regime change and its unique economy. So nothing drastic will take place. The key is for the leadership to control social unrest by implementing sound economic policy. Also, keep track of the savings rate, which has been very high, in part due to a lack of investment alternatives for the average Chinese national. If it decreases, it will certainly impact domestic investment as well as China’s appetite for foreign sovereign debt.

Are Chinese Business Practices Unique?

Yes. Things are done differently here. For instance, boards do not play as influential parts of strategy and governance as in the West. Official contracts aren’t signed, but stamped. Hiring guidelines and policies resemble more like unionized labor, despite it being communist.

What are Some of the Biggest Investment Challenges?

1. Information – It’s hard to get access to the right information, not necessarily because the other side is intentionally withholding information, but because the disclosure standards and culture are different.
2. Regulation – There is significant regulation and government intervention in all aspects of business.
3. Governance – Lack of board oversight because Chinese boards do not play same role as western boards
4. Revenue Diligence – An investor needs to clearly understand and map a company’s revenue streams, as often the sources of these streams go away post-acquisition, so off-balance sheet relationships are key to diligence.
5. Government Support – An investor needs to understand and gain support of government across all levels. Local provinces are very strong, so investors need to understand their angle and local policy. One should always get government approvals in advance and then proceed with a transaction.

What are Some Due Diligence Best Practices?

1. Record Keeping – It is fairly common for a local company to keep multiple set of books, as there is widespread underpayment of taxes (which are often negotiated). When you locate the right set of books, the fact that they often don’t deploy US GAAP standard makes it challenging to reconcile their accounts.
2. Government Influence – One must determine the level of government interaction with the target company. Is there an overhang? Does the company benefit from favorable government contracts/benefits, which may go away post-acquisition?
3. Inter-related Activities – A local company may benefit from a web of side business (often with different relatives). Some of these relationships are not even bound by contracts and could go away post-acquisition as well. And in some instances, owners have been found redirecting some of the target’s business to another company, right before the acquisition.
4. Intellectual Property – The Chinese enjoy home field advantage given the loose IP laws and the intricacies involved in suing for damages in China. This will change over time, but one must be vigilant and implement risk mitigation practices to minimize potential exposure.

DAC’s extensive sourcing and due diligence unit in Beijing is heavily grounded on the concept of a thorough local-influenced due diligence approach, which is often sought by the largest foreign PE and VC firms. The company’s diligence includes: financial, operational, background checks, government research, target market, and more. DAC also plays a strong role post-acquisition, as it often deploys one of its senior financial managers to oversee the accounting process and auditing.

 For more information, please contact Phil Groves at pgroves@dacmllc.com.