The SEC crackdown on Chinese reverse mergers has made Chris Rynning's job as the head of a Beijing-based private equity firm a little easier.
A few years ago, hiring top-quality advisors, bankers and auditors made little sense to a penny-conscious Chinese entrepreneur. "Why bother spending the extra money?" they'd ask Rynning after he pitched the idea.
But recent allegations of fraud at a handful of foreign-listed Chinese stocks has pushed investor sentiment to an all-time low. And now, mainland entrepreneurs that want to be taken seriously by overseas investors are more open to heeding Rynning's advice, as well as accepting his strict investment terms, and rigorous due diligence process.
"I put people on my payroll to sit in the offices of the companies I invest in. We hire our own financial controllers to sit in the portfolio company offices so that they see when the founder is coming into the office, who they meet with, who pays who and why," said Rynning, chief executive of AIM-listed Origo Partners, a $300m foreign PE fund based in Chaoyang, a busy financial district in Beijing.
"I'm not surprised there's fraud in China. It's not whether it happens, but how to protect yourself against it," he told FT Tilt.
Rynning learned this lesson the hard way: in the nineties, he agreed to invest $300,000 for a 30 per cent stake in a Beijing-based company that had been set up by three Chinese entrepreneurs who had just quit their jobs at a multinational corporation.
A week later, the entrepreneurs asked him to raise his investment to $600,000, and reduce his stake to 15 per cent. Rynning tried to renegotiate, but to no avail. He refused to pay up so the entrepreneurs closed the Beijing company and fled to Shanghai, where they had incorporated the exact same entity in anticipation that Rynning would back down.
Fortunately, Rynning didn't lose his entire investment: he invested only in instalments, and lost the initial $60,000 he had already poured into the company.
To this day, Origo Partners uses a similar strategy, which Rynning calls "carrot and stick" investment: "I invest more in the company after they've reached milestones, and punish them if they don't."
The biggest mistake hedge funds and foreign investments (PE included) make in China is that they don't put their own people on the board or in the offices of the companies they invest in, Rynning added.
But not all agree to his terms: "Some companies tell me to 'take a hike,' and that's fine. Then we'd rather not make the investment."
Pre resignation letters and Big Four auditors
With some companies, Rynning sometimes requests pre-signed, undated resignation letters in the event that an employee or director has violated a contract. "I can remove the person and go to the government to prove termination," he said.
Without these pre-dated resignation letters, the employee could potentially not quit and "bring in advisors to make all sorts of claims against me."
Rynning admits he may sound paranoid, but taking "pre-emptive" measures, especially in an emerging market like China, is what many investors fail to do.
What about hiring Big Four auditors? It's crucial that Chinese companies hire the actual auditor, not the locally appointed one, which is what often happens, Rynning said.
The problem is that not all top auditors are set up to do the "China ground work," he said.
Big Four auditors typically audit the offshore company, and sends the partner to China to verify with a locally appointed firm that the China audits are correct.
"This is much more vulnerable to fraud as it gives the company the opportunity to influence the local firm advisor," Rynning said.
These types of stories are common in China, and as one merchant banker in Beijing told FT Tilt: "The SEC crackdown on Chinese reverse mergers doesn't surprise me. Everybody here knows that a Chinese company has four separate accounting books."