Caterpillar Caper Bugs China's Private Equity Market

TAIPEI (TheStreet) -- Caterpillar (CAT) is known as a careful company. The world's top producer of construction equipment is no stranger to China with 23 manufacturing bases and 15,000 workers. So when the firm announced accounting fraud at a recently merged Chinese firm, it made investors look again at the country.

We're supposed to think China gushes with income for private equity investors who buy profitable local firms, in boom industries such as construction and at the right prices.

Caterpillar must have thought it had scaled that great wall of gold when it bought Hong Kong-listed ERA Mining Machinery Ltd and its subsidiary Siwei in mid-2012. The U.S.-based company with 2011 revenues of $60.1 billion had paid the equivalent of $653.4 million for Siwei, China's fourth-largest maker of hydraulic roof supports.

We're also supposed to remember that this is China. Rule of law is weak, so the weak, or even the strong, easily get scammed.

And being screwed is not the only problem with Sino-foreign private equity deals. There's at least another big one -- as well as hope for the wiliest dealmakers.

As the Caterpillar caper was unfolding, I talked to C.Y. Huang, chairman of the Taiwan Mergers & Acquisitions and Private Equity Council. His Taipei-based investment bank has brokered more than half a billion U.S. dollars in the past two years, leading foreign funds to mainland Chinese companies in food service, cosmetics, packaging and tea retailing.

Huang says the trick is doing intensive background checks to avoid scams but stop just short of so much diligence that the Chinese party gets angry and walks off.

"Upon your nice face, who knows whether you are a crook or a scoundrel?" Huang says.

Caterpillar found the problem during an inventory check of the Chinese firm and announced plans to take a goodwill impairment charge of $580 million. Calling the case "deliberate misconduct" that began several years prior to the acquisition, it also fired some of the scoundrels and hired better people.

"The actions carried out by these individuals are offensive and completely unacceptable," Caterpillar CEO Doug Oberhelman said in a statement on Jan. 18. "This conduct does not represent, in any way, shape or form, the way Caterpillar does business or how we expect our employees to work."

Apparently investors know that. Share prices for the world's largest maker of earthmoving, construction and mining equipment fell 2.19% from Jan. 22 to Jan. 25, but they have risen past the Jan. 22 level since then.

In what has shaped up as an iconically famous case, Toronto-listed Sino Forest Corp. was accused by a short seller in 2011 of overstating revenue and giving false numbers about its timber acreage rights in China. The Canadian stock exchange forced the company to delist last year.

According to the online business news website Quartz, U.S. investors in China have lost billions of dollars after alleged accounting problems pushed more than 100 Chinese companies off stock exchanges in Canada or the U.S.

Still, major private equity firms such as Goldman Sachs ( GS), Carlyle Group ( CG) and KKR & Co. ( KKR) have proven they know how to work the China market.

Carlyle alone has invested around $4 billion in China, covering 60 deals, the state-run China Daily newspaper reported last year without giving a source. In July the group bought a 49% stake in Mandarin Hotel Holdings of China and will "work with it to tap the country's emerging mid-tier hotel market," the newspaper said, speculating that the deal was worth a high eight-digit figure.

There is no immediate reason to imagine these companies will be scammed.But Huang, among others, complain that all foreign investment firms in China face another barrier -- the recent formation of some 10,000 cutthroat local rivals doing business in Chinese yuan. They understand the Chinese market and deal-making mentality. Thanks to China's rapid economic growth over the past decade, they also have as much money as their foreign competitors. In 2010, yuan funds outraised foreign currency funds.

You have to do more than look good, says Justin Knapp, director of China outbound practice at Ogilvy Public Relations in Beijing: "Both RMB and overseas PE funds are increasingly being forced to tell a better story to companies as to why their money is more reliable. It's like a dating service that is developing quickly only it's between companies and private equity funds."

That means foreign investment funds must offer something such as a strategic alliance -- maybe access to unusual new technology -- that the local ones lack.

If nothing else, they need at least the same crew of outside legal, financial and accounting pros that Caterpillar hired to examine Siwei before the acquisition. Cat says those experts were hardly sleeping on the job.

"To have something blow up so soon, that's a mystery," says Jack Perkowski, China private equity veteran and founder of the merchant bank JFP Holdings in Beijing. "Caterpillar is a very careful company. They do their homework."

And Caterpillar says buying Siwei may be worth it: "At this point, there are no plans to remove the Siwei name," the statement says. "The company maintains a strong reputation in the marketplace. Caterpillar intends to build on Siwei's strengths."

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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