CVC’s Failed Investments in China
- AVN
- Jun 28, 2019
- 3 min read
Updated: Aug 19, 2019
China’s rapid economic growth has made it an appealing destination for global buyout firms. However, private companies often need more scrutiny due to their limited disclosure rather than publicly traded companies with years of audited accounts.
Looking back a few years, CVC Capital Partners, with $70 billion USD of assets under management, was a victim of manipulation in their China acquisition of high-end Sichuan restaurant chain. Let us take a closer look at the case of Europe’s largest private equity fund company and South Beauty.
The Background
The South Beauty Group, which was founded in 2000, had managed to maintain profitability for 8 years while its sales reached about 1 billion RMB. They also won the prestigious contract to become the only food service partner of Chinese cuisine for the 2008 Beijing Olympics Games. The founder, Zhang Lan, has been honoured the World Entrepreneur of the Year - Ernst & Young.
There were some warning signs prior to their acquisition. In 2012, the company failed to get listed on the domestic stock market even though South Beauty was at its prime with $160 million in revenues. Next, Zhang Lan went to seek a Hong Kong listing but eventually gave up due to its low valuation. However, such warning signs did not deter CVC from investing in South Beauty.
The Acquisition
In December 2013, CVC invested US$286 million in South Beauty, amounting to 82.7% of controlling interest in the business. The valuation formula for the company was based on a multiple of 13x the company’s estimated 2013 consolidated net profit after tax, which in turn was based on the projected growth rate of the South Beauty business in 2013.
However, even after doing their due diligence by hiring an accounting firm ahead of the deal, CVC failed to realise that South Beauty’s financial statements were being manipulated.
Here are the highlights of the manipulation that was found out:
1) Falsified transactions recorded that a group of 5000 diners were eating at their Beijing Financial street branch which only had a seating capacity of 382. They were recorded ordering 15,000 dishes, completing their meal within 55 minutes and was charged on account.
2) There were many cases of using a single credit card to settle multiple client accounts and the client accounts are in the names of employees of the restaurant.
3) The manner in which the accounts were settled suggested that South Beauty was settling falsified transactions using their own funds to make it seem that legitimate sales were occurring.
4) Precise documentation of the manipulation done by the management was found, which includes explanatory notes stating the areas which were falsified. (Eg. “increase revenue”, “falsify costs”)
Even the biggest of all companies are prone to judgement errors. Despite subtle warning signs—failing to be listed on the domestic stock exchange and obtaining low valuation in Hong Kong— CVC went ahead with their acquisition deal.
Since this incident, CVC has not made a new investment in mainland China.
CVC’s other investments in mainland China
They also lost money on other China deals. The Wall Street Journal stated that 5 out of 8 of CVC’s investments in mainland China over the past years had lost money, despite the fact that the firm’s Asia fund overall had generated a 20% annualized return. Here are the list of CVC’s investments and their returns:
Ultimately, this case represents an important lesson in due diligence where specialised and intimate knowledge of the firm may have averted this crisis. Undoubtedly, there is a real need for such services to be more readily available to protect investors from making such investments.
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