Fertile territory for turnarounds

Chinese companies coping with economic volatility and regulatory reform are now looking to upgrade their operations, creating the right climate for restructuring opportunities. Rob Kotecki reports.

For some time, Asia primarily offered two types of opportunity to private equity investors: managing the runaway expansion of companies in China, India or other growth markets, or helping with turnarounds at mature Japanese corporations. These opportunities remain, but in addition, recent developments in China are creating the country's first demand for turnaround expertise.

To be sure, the country is hardly in danger of a significant downturn. China appears poised to surpass Germany as the third largest economy in the world this year. Yet much of its growth is fueled by exports, and Chinese companies are not immune to difficulties in the US, their largest export market. A year and half ago, they might have waved off suggestions of restructuring, but now the confluence of several factors have many searching for an operational overhaul.

A weak and falling US dollar, rising production costs and cuts in trade subsidies are eroding profits at many Chinese companies. Tighter credit policies have dried up refinancing options, leaving managers few options but to improve their operations. This has yet to produce a wave of deals for buyout firms, but a handful of general partners are ready to provide their expertise in exchange for equity. These early birds would do well to remember that China still lags the West in middle management talent and performance measurement. Local restructuring experts suggest that while companies may be willing in theory, they often are considerably less ready in practice.

FLAT WORLD FACTORS
China has benefited from the current wave of globalisation, but the country is learning that Tom Friedman's “flattened world” is a mixed blessing. China's economy may have accelerated by trading with Western economies, but when international markets falter, the ripples quickly reach Chinese shores.

“With so many companies built around a vibrant export business, the depreciation of the US dollar has a real impact,” says Ivo Naumann, managing director and head of the Shanghai office of international turnaround consultant AlixPartners. Naumann notes too that the government's elimination of export trade rebates on over 550 categories of goods is also applying pressure. “The end of subsidies and currency moves can siphon up to 16 percent off a profit margin,” says Naumann. “And for companies in industries like auto parts that are already operating with margins of 7 or 8 percent, those events are a wake-up call.”

Turnaround specialists also report that a new labor law implemented in January has raised the cost of labor for several manufacturing companies. Throw in rising energy costs, and it is no revelation to learn that Chinese companies are increasingly interested in reviewing their cost structures. “However, not all those cost increases can be transferred to the customer,” explains David Maund, a managing director of the Hong Kong office of Alvarez & Marsal, another global turnaround consultancy.

Maund also stresses that there are longer-term forces at play in China's newfound willingness to consider operational intervention. “Chinese businesses are looking to better compete with their more-established foreign competition and eventually expand overseas, so international best practices become more relevant,” he says.

Stewart Winspear, who is in charge of the firm's Shanghai operations, finds that a tightening credit environment is limiting the financing options available, signaling a potential upturn in restructuring activity. The government in Beijing has made several policy measures to mop up excess liquidity in response to concerns about inflation, and local companies are left to look for alternatives to improve their margins.

A BOOM IN THEORY, NOT REALITY
All these factors may argue for a sharp rise in turnaround activity, but that boom hasn't materialised. There remain real managerial and cultural hurdles to the practice of foreign tinkering with local companies.

“Generally speaking, there's still reluctance for Chinese businesses to engage outside consultants unless there is a trigger, such as an influential investor pushing to understand why actual performance doesn't match with the projections provided prior to the deal,” says Winspear.

Given how few Western firms manage to close deals to become such “influential investors”, the lack of turnaround activity is hardly a mystery. However, advisers such as AlixPartners and Alvarez & Marsal have opened offices in Hong Kong or Shanghai, and a few buyout firms that once relied on China solely for portfolio company sourcing are now looking to collaborate with local companies on deals.

One such firm is US-based Sun Capital Partners. The firm initially employed its Chinese relationships to develop outsourcing solutions for its Western portfolio companies, with an office in Shenzhen. Now the firm is opening an office in Shanghai to capitalise on joint venture and add-on opportunities. “We've felt that our experience for operational improvement is well suited for the country at this point,” says Victor Gao, the firm's managing director in the country.

Sun Capital has already orchestrated some turnarounds in Japan. For instance, the firm's Tokyo team, established in 2006, acquired KK Tarami, an underperforming producer of fruit gelatin deserts, as part of a “consensual restructuring agreement” which appears to be performing well with Sun's counsel. Gary Talarico, a managing director at the firm, explains: “The great thing about working with Japanese managers is that once they reach consensus on an initiative, they are all about execution.” Although Talarico admits that winning that consensus in Japan is no easy task.

“In many ways, China is on the cutting edge for technology and innovation, but the ways of doing business here are very traditional, closer to New York in the 1920s with its etiquette and slower pace.”

THE EXECUTION GAP
Turnarounds in China often offer a rather different dynamic: swifter consensus, but a prolonged execution. “The top layer of managers is great at the vision thing, crafting bold strategies for growth and reform – but are then hampered by thin talent at the mid-management level to implement many initiatives,” says Naumann. He explains that the country's relatively short history of a market-driven economy has slowed the development of a middle-tier managerial class. “So senior managers need to have a much better grasp of what lower tiers of management are doing,” he says.

One of the recurring issues turnaround consultants encounter is a lack of reliable performance metrics to measure key aspects of an operation. “This is often a result of rapid growth in a company without a corresponding effort to develop and implement the right management tools and controls to support a significantly larger and more complex business,” says Maund. “Proper KPI [key performance indicator] systems grant the top managers a better view of actual performance throughout an organisation, which means faster reaction time and more tailored reforms, ” says Naumann.

Even with improved KPIs, most consultants and GPs stress that any sort of operational reforms thrive or fail on the strength of relationships. “It's impossible to overestimate the importance of having a real rapport with your local partners,” says Gao. “In many ways, China is on the cutting edge for technology and innovation, but the ways of doing business here are very traditional, closer to New York in the 1920s with its etiquette and slower pace.” The fact remains that Beijing regulators remain slow to approve foreign bids for even minority stakes, the purchase of which would be the first step in any private equity-driven turnaround effort.

Restructuring work in China may be in its infancy, but plenty of consultants and buyout firms are counting on that infancy to be brief. “You have to understand that China has been undergoing radical changes for almost three decades now,” says Gao. “The changes have come so quick that there's almost a generation gap every five years, and a new country every ten.” Restructuring experts are hoping that next new country to emerge will be quick to employ reforms to enable better restructuring – and thus to help maintain China's growth.