Distressed diplomacy

Distressed investors in China and Japan can rarely rely on formal control to improve the fortunes of their targets. Successful workouts require a blend of local talent, rigorous due diligence and above all, a healthy dose of diplomacy. Rob Kotecki reports.

A famous critic once wrote that ?diplomacy is to do and say the nastiest things in the nicest way?. Distressed investors take a more generous view of the art of enacting the ?necessary? changes at a given enterprise. More often than not though, their diplomacy is anchored in a solid equity stake that underpins their soft speak. In Asia, however, where majority stakes can be difficult to come by, foreign investors are relying on diplomacy all the more.

?Asian distress? is often associated with the currency crisis of the late 1990s. Since then the market has changed considerably, with healthier businesses and more competition. Among the most attractive markets for turnaround investors are Japan and China. The former has a mature and improving economy where companies struggling to keep with the pace can be subjected to classic turnaround plays; China, with its unbridled growth, offers mostly distressed debt opportunities that require the involvement of often fickle courts.

However different the two countries may be though, experts cite aspects that are common to both. For example: sourcing distressed opportunities in either place involves deep due diligence into balance sheets and human capital. Conducting that research, winning the deal and improving operations all require local talent to overcome very real cultural barriers. Every phase of the deal cycle requires a gentle touch, though if the management or the courts don't approve the enforcement of the turnaround plan, all the tact in the world can be for naught.

Given current conditions, there is a slim margin of error for players moving into the arena. ?Today's challenges are not what they were seven years ago,? says Rick Hayes of California-based Oak Hill Investments, who was the senior investment professional at CalPERS during the pension fund's Asian forays of the late 1990s.

For one, the definition of ?distressed? is expanding, as many participants now use the word to refer to merely ?underperforming? companies, not just nonperforming loans (NPLs) or enterprises on the cusp of insolvency as it was in the fallout from the Asian crisis.

JAPAN: CONSENSUS-DRIVEN
The new paradigm for distressed investing means different things for Japan and China, respectively. The two countries are on distinct trajectories, each with their own benefits and risks. Japan's mature economy and sometimes insular business culture grants it the virtues of a lone wolf: highly experienced but sometimes slow to change.

On the face of it, the Japanese market has many appealing characteristics. ?Japan is full of companies with long histories of a pattern of profitability. There's a large middle market, and opportunities in every sector- it's a diverse economy,? says Gary Talarico, a managing director at US turnaround specialist Sun Capital who leads the firm's New York and Tokyo offices. Furthermore, professionals who know the market well say that transparency is improving, and that the regulatory framework can be relied upon.

However, the perception of private equity-style investment activity isn't entirely positive. Keith Gillespie of the turnaround consultancy Alix Partners says: ?In Japan there remains a lack of understanding of private equity on the sell side. Many potential sellers are concerned about financial buyers focusing solely on profits, especially given some of the large gains that private equity funds have achieved in recent deals in the country.”

Nevertheless, there have been transactions that indicate a willingness to work with private equity in turnaround situations. In May of this year, Sun Capital acquired KK Tarami of Japan, a producer of popular gelatin deserts with revenues in the range of $100 million. Tarami was losing market share to competitors and suffered a failed product launch, resulting in the highly leveraged company losing revenues and inching towards insolvency. Sun and Tarami agreed to a ?consensual restructuring? of the company, the details of which were not made public.

CHINA: EARLY DOORS FOR DEBTFOR-EQUITY
China's distressed opportunities consist primarily of distressed debt in the form of packs of NPLs as state banks strive to clean up their balance sheets. The challenge for turnaround investors here is to identify suitable targets. Companies that are performing poorly often have access to local capital helping them to stay afloat without any private equity rescue efforts. This is why many private equity firms are going after growth, not turnaround opportunities.

That said, distressed debt investing in China is going through an evolution. At a recent Emerging Markets Private Equity Association (EMPEA) event in Washington DC, Rob Petty, the managing partner of New York-based Clearwater Capital Partners, pointed to a blending of distressed debt and classic private equity in China, explaining that buying up debt was emerging as just another way of entering the capital structure. By way of debt for equity swaps, investors can take ownership of the underlying company and therefore acquire greater influence over a company's operations. ?Debt for equity swaps give you a chance to weigh in on an acquisition strategy and make changes in management personnel,? says a turnaround professionals.

To be sure, the trend of Chinese distressed debt turning into equity positions is still at a very early stage. For the time being, the most common approach to NPLs is still the traditional way through the legal system. According to market practitioners, Chinese courts are proving useful when it comes to restructuring balance sheets, even from the point of view of foreign investors.

Benjamin Fanger is a co-founder of Shoreline Capital, an alternative investment specialist pursuing strategies in distressed debt, distressed real estate and other special situations and working from offices in Guangzhou, Shenzhen and Changsha. He explains: ?China gets a bad rap. Sure, it's based on legitimate facts about the legal system's inconsistent record and certainly unexpected things happen here. But even where a borrower may have a close relationship with a specific judge, it takes a lot to get a court to take a truly egregious act against a foreign investor. Their regulatory system and their enforcement of commercial law is still a work in progress, even more so outside of the major cities. What a casual observer may see as a fickle or prejudicial decision, a closer look will reveal genuine uncertainty as to what precedent to set. And that uncertainty can cut both for and against foreigners looking to use courts in debt restructuring projects.?

Fanger's pragmatic optimism appears to have served Shoreline Capital well. He says the firm has purchased over $70 million in NPLs over the past eighteen months alone, and is beating the 25 percent IRR hurdle rate on realised investments.

LOCAL TALENT PRICELESS
Regardless of whether the transaction involves restructuring debt in China or streamlining operations in Japan, there are certain practices that no investor chasing distressed opportunities in either country can afford to ignore. The first, and arguably the most important, is the need to bring aboard local talent for the sourcing and due diligence of deals and the management of the recovery process.

?You need to have local expertise on the ground searching for deals. Their networking and relationships are just vital for finding opportunities these days,? explains Hayes at Oak Hill. While transparency is improving in both countries, locals can be uniquely capable of discerning the hidden value of assets and managers.

?If a conglomerate is to sell a particular division, they want to know how the buyer plans to grow that business into a self-sustaining entity.?

Another GP says having a local team member sourcing distressed assets is all the more important in Japan, given the hesitancy of executives to speak openly of performance difficulties. A local executive will have relationships close enough to inspire a frank discussion of the company's health.

However, one turnaround consultant warns that in certain cases, once a Japanese executive joins the ranks of a foreign investment firm, he loses some of his status as a local partner. In China, this is less of an issue: according to a lawyer currently advising on Chinese distressed investment, the country's business culture is decidedly friendlier towards locals employed by foreign firms.

Some market participants stress that the influx of foreign private equity firms into both markets has created a scarcity of local talent. While not all the groups are competing for distressed opportunities, they are after local investment professionals to give a familiar face to their effort in sourcing deals and steering operations.With top tier LBO funds like KKR and TPG announcing sky-bound fund targets and establishing offices to manage their billions, the battle for local talent is arguably inevitable.

?Large firms simply have the capacity to pull the industry and local talent in-house,? says Gillespie. ?This creates a highly competitive market for talent with local roots and international experience.?

Sun Capital's Talarico explains: ?The lack of mobility in Japan's job market and the relative security of a manager's position mean there are fewer high quality executives looking elsewhere for opportunities.? Some foreign firms are tapping the resources of turnaround consultants using their experience working alongside local managers with restructuring experience to source human capital.

DISCERNING FACT FROM FEELING
A partner of a middle market firm explains that without the resources to hire vast numbers of locals, nurturing informal relationships is the next best thing. Turnaround consultants warn that swapping business cards and calling every three months is not sufficient. There needs to be genuine value exchanged between parties, with foreigners granting access to their professional networks and paying for advice that leads to closed deals or hired staff.

With some variety of local talent aboard, the sourcing of opportunities can commence. Once it has, given the nature of distressed investing, due diligence takes on massive significance. When investing in minority positions, or even in politically sensitive control deals, it is crucial to know all the liabilities and plan for them appropriately. In Asia, says one insider, the due diligence process is not a time to trust your gut instincts.

Sources interviewed for this article agreed that China is generally quite friendly towards doing what's necessary to save an enterprise. Officials and management are temperamentally biased towards safeguarding jobs, but there is also willingness to take some short-term pain in the interest of long term growth.

However, given that the Chinese mature economy is less mature than Japan, there are a host of assets and liabilities that aren't necessarily on paper. Investors are advised to identify all stakeholders that may not be formally tied to the company. These may include government officials or bank management that may be in a position to slow down or speed up a recovery to safeguard their interests. These will be all the more vital to identify in situations where the restructuring of loans will be taking place in the courts.

GROW FIRST, PRUNE LATER
In Japan, a company's social obligations towards employees remain strong and relevant to turnaround efforts. ?Buyout firms need to orient their stories towards revenue growth. If a conglomerate is to sell a particular division, they want to know how the buyer plans to grow that business into a self-sustaining entity,? says Gillespie. The responsibility to employees requires that any measures taken to improve efficiency, particularly redundancies, need to be handled patiently. One consultant suggests that efficiency reforms that may take 12 months in the US may require 18 to 24 months in Japan.

The other cultural note to stress is the country's reverence for personal experience and maturity. One consultant says that when negotiating with senior management and conducting due diligence, older partners should be the face of the investor's operation, because Japanese corporate leaders, who are often over 50 years old, expect to be dealing with counterparties of the same age.

?In Japan, many potential sellers are concerned about financial buyers focusing solely on profits.?

DUE DILIGENCE: EIGHT KEY QUESTIONS

When looking at turnaround candidates in China and Japan, make sure you ask about the following:
1)Who has the title to the assets? China is one of the Asia countries where land rights are not maintained through the sale.
2)What's the quality of the information? Bank statements should be reviewed to test cash flows.
3)Where are the hidden assets and liabilities? Who has an interest in the company's success or failure?
4)What's the quality or reliability of management? Dig deep into the background of senior management.
5)Is there any unexpected liquidity or credit available? This includes assistance from the government, non-economic/ relation-
ship based loans and vendor or customer assistance.
6)Are there hidden supply chain or working capital costs? Be aware of any product sitting in a warehouse that has already
been booked as revenue.
7)Is there a fragmented market posing roll-up opportunities?
8)What's the contingent social costs not on the balance sheet?