Monday, April 4, 2011

Quanxi: Get yourself connected

I have worked a few times in Puerto Rico after Hurricanes did a steamroller over the island.  I was working on assessing damage to individuals’ homes so that they could receive some repair money from FEMA.  I was a contractor, but generally a person that people did not mind seeing.
One of the times I was there, it was election season.  There would be these long line of parading cars, and lots of enthusiasm.  It was nice to see such civic interest.
As time went on, one of the reasons for all of this civic interest became obvious.  The United States has developed the bureaucratic model of civil service:  the politicians come and go, but the worker bees (aka: the person taking forms at the Clerk of Courts Office) keep their jobs.  In Puerto Rico, that was not necessarily the case.  If you worked at the counter at the Clerk of Courts Office, and your party lost the local election:  you were likely out of a job:  To the victor goes the spoils.
Needless to say, when a large chunk of the local populaces’ jobs are on the line, people take great interest in the local elections.  And people notice whose parade you attend.
Now one thing that Puerto Ricans attached great importance to was paved roads.  You could be out in the middle of nowhere in the depths of the Mountains, and the road to a little urbanization (village-development) would still have its road paved.  Most counties outside of the Boroughs of New York City have more unpaved roads than your typical Puerto Rican municipios.
However, I do remember visiting a small street in the middle of a medium size town and as we sat on the front, it dawned on me that it was unpaved.  I asked our host why he had the only unpaved street in the town.  Was this a famous street of desperados that chased away the paving crews?   He laughed, “No, none of us belong to the mayor party.”
And that is how we come to Guanxi . Guanxi describes the basic dynamic in personalized networks of influence, and is a central idea in Chinese society.
Guanxi is how most of the real world works.  If we postulate the remote possibility that the United States of America, and Western Europe are more past than in their prime, it is a concept that we may want to learn.
I have found a few examples.  The first is from John at Bronte Capital.  I really like Bronte Capital’s secondary title:  “It’s a small world but I wouldn’t want to paint it”.


Guanxi vs Analyst: Carlyle and the coming collapse in Asian Private Equity

I have a friend with a fair career as an analyst in Asian private equity funds.  He describes the central debate as being between the “Guanxi guy” and the “Analyst guy” (in his world they are mostly guys) and he says the “Guanxi guy” has won almost all of the battles…
At Private Equity (PE) firms the debate as to which deals to do and what price to pay has been between the Analyst guys and the Guanxi guys - and with the Guanxi guys winning almost every time.  Analysts - when they have reservations about deals - are seldom heeded.

Some analysts - not wishing to besmirch their reputation with bad deals done for the wrong reasons struck out and started their own small private equity funds.  When they find the deals they try to fund them and discover that the banks (or their Guanxi connections) want to take a piece of the equity.  I guess that is the price of doing business.  But even after paying up they find the banks want to charge them over-the-odds for funding.

So the deal goes to some Guanxi guy - and the banks queue up to do the funding at low spreads.  (Whatever you say Sir says the banker...)

And so - in the great Guanxi vs. Analyst debate Guanxi repeatedly wins.

Guanxi is less important in the West - but connections remain important.  The definitive Western Guanxi firm is Carlyle.  Carlyle is a private equity firm known for employing senior political figures and using those connections to win deals - but also for their knowledge of how government functions.  The list of famous employees is large and include:
  • George H W Bush
  • George W Bush
  • James Baker (former Bush Secretary of State)
  • Mack McLarty (former White House Chief of Staff under Clinton)
  • John Major (former British Prime Minister)
  • Anand Panyarachun (former Thailand Prime Minister)
  • Fidel Ramos (former Phillipine President)
  • Arthur Levitt (former SEC chair)
I could go on - the list is extensive...

Alas I think Carlyle’s business model in Asia is fundamentally flawed: we can see this through a purely hypothetical example.

Imagine if Chelsea Clinton went to work in business and to sell her connections.  (I know nothing about Chelsea Clinton other than she got married recently - so this example is purely hypothetical.)  And suppose that with considerable hard work at some Wall Street or Private Equity shop she wound up with $5 million.  (As I said I know nothing much about Chelsea.)  We would not be terribly surprised if Chelsea wound up with $5 million - we might think it unseemly - but it would also by Western standards not be terribly surprising.

However if Chelsea - through nothing other than her connections - were to wind up with (say) $500 million then that would be unseemly.  Journalists would be all over the story and the integrity and morality of the people involved would be questioned.  Indeed it would be so unseemly it would not happen.  

There is a line here - $5 million is sort-of-OK.  $500 million is clearly not.  I suspect the line is at high single-digit or low double digit millions.  Obviously the line is higher for a President than it is for a President’s daughter.  Whatever: the social sanction matters.*  The cynics would argue that there is a socially acceptable amount of looting.  I prefer to think that wages - particularly of people who sell their “Guanxi” are socially conditioned.

And thus we see Carlyle’s problem in Asia.  In the United States the Guanxi guys will work for single-digit millions annually and think they are well paid.  That is all they are entitled to.  Such limitations on entitlement do not exist in Asia - and the Guanxi guys are likely to see Western funded private equity shops like Carlyle as piggy banks to loot.  Sometimes they will be looted by the Guanxi staff but more likely they will be looted by Guanxi connections of of the Private Equity shop's Guanxi staff.  And the looting will not be a million or two dollars here and there - it will be for every penny they can extract.  The losses could be enormous.

To this end I present to you China Forestry.  China Forestry was a billion USD Hong Kong listed Chinese company with many Private Equity funds having stakes.  The leading stakeholder is Carlyle (or more precisely funds belonging to Carlyle’s clients).  The stock has been suspended after admitting “accounting irregularities”.  But it is worse than that.

China Forestry had a business model which consisted of fast-growth forestry to extract greenhouse gas credits - a business model that barely made sense to some analyst guys that looked at it.  However, it was a business model that made sense if the company had enough Guanxi - enough connections to extract a really bad (i.e. nonsensical) deal from the Chinese government.  And the holders of China Forestry to some degree believed just that.  They believed in the Chinese Guanxi.  And implicitly they believed the deals were being bought to them by the Guanxi of their staff.

Now China Forestry remains suspended.  No reasonable questions are being answered - so I am going to reveal to you the Analyst gossip: the bulk of the forests do not exist.  Sure they had some “front” - plantations they would take potential investors to.  But the vast bulk of the business was a fiction and “accounting irregularities” is code for “fiction”.

Oh - and Carlyle has dusted 105 million dollars.

If this is fraud then Carlyle has a little egg on their face.  After all - what is the point of having all those investment professionals if they get dusted by the simplest of frauds?  The whole point of private equity is that by pooling capital you can get insider positions and you can run the company for cash - for the benefit of your investors.  But if your “insider position” doesn’t even allow you to spot the business does not exist then your insider status is worthless.  You might as well close up and go home.  You have no right to be in business.

If you wish to see more of what the author speaks of there is another funny posting here.

It has truly funny frame-by-frame display of a Potemkin Village (A show village that is only a facade) style factory used to convince investor to part with their cash.


 We now proceed to London Review of Books:  Diary by Peter Pomerantsev.

Mr. Pomerantsev discusses how in 2006 he went to Russia to join with a television production company.  The whole peace is interesting, but I will only mention his section that details the problems of translating American reality show concepts to Russia:


The fundamental premise for most Western reality shows is what people in the industry call ‘aspirational’: someone works hard and is rewarded with a wonderful new life. The shows celebrate the outstanding individual, the bright extrovert.

For the Russian version of The Apprentice, Vladimir Potanin, a metals oligarch worth more than $10 billion, was recruited to be the boss choosing between the candidates competing for the dream job. Potanin goaded, teased and tortured the candidates as they went through increasingly difficult challenges.

The show looked great, the stories and dramas all worked, but there was a problem: no one in Russia believed in the rules. The usual way to get a job in Russia is not by impressing at an interview, but by what is known as blat – ‘connections’. Russian society isn’t much interested in the hard-working, brilliant young business mind. Everyone knows where that type ends up: in jail like Mikhail Khodorkovsky, or in exile like the mobile phone billionaire Yevgeny Chichvarkin.

Today’s Russia rewards the man who operates from the shadows, the grey apparatchik, the master of the politique de couloir – the man like Putin. Promotion in such a system comes from knowing how to debase yourself, how to suck up and serve your master, how to be what the Russians call a holop, a ‘toady’. Bright and extrovert and aspirational? Not if you want success.

The shows that did work were based on a quite different set of principles. By far the biggest success was Posledny Geroi (‘The Last Hero’), a version of Survivor, a show based on humiliation and hardship. This chimed in Russia – a country where being bullied by the authorities is the norm.

As noted above, if you are on the wrong side of the equation:

An aide to the Moscow judge who convicted oil tycoon Mikhail Khodorkovsky said he didn't write the verdict and was closely supervised by senior officials throughout the trial…the judge's original draft of the verdict was rejected and that he was ordered to read one written by senior officials at the Moscow City Court. Gregory L. White, The Wall Street Journal, February 15,2011.

No comments: