Instead of gathering to celebrate their many successes in Asia during the past year, American private equity firms in Japan, Korea and China are busy meeting with their peers, attorneys, accountants and PR agents, trying to figure out how things have gone so wrong for them, so quickly and in so many places.
The world in which the differences between the rich and the powerful are resolved in tony restaurants, often with behind-the-scenes accommodations, vanished in early April when investigators from the Korean National Tax Service showed up at the Seoul offices of Lonestar Partners and The Carlyle Group demanding access to documents and files that were summarily carted away in what a Korean private equity professional described, at least in Carlyle’s case, as an “invasion.”
The ugly scene in Seoul took place just days after Japanese legislators passed the so-called “Shinsei Tax” on April 1. The tax of 20% is to be applied exclusively to the profits of “gaijin,” or foreign private equity firms, that have had the temerity to purchase, reorganize, operate and successfully exit from domestic companies in Japan. More troubling, Japanese legislators also modified their tax regulations to ensure that the tax is “passed through” to minority investors (limited partners) in foreign PE funds.
At about the same time in Beijing much of the country’s PE community met on March 30 in an hours-long gathering that at times resembled a torch-lit rally, in which foreign investors and their advisors decried the January introduction of a new regulation by the State Agency for Foreign Exchange. The new reg stops the unregistered trading of assets in offshore companies owned by PRC nationals or foreigners resident in China and thus indirectly relegates to the trash bin the successful “WOFE” structure used by U.S. PE firms to buy and exit private investments in China.
Nicolas Bloy, a co-founder of Malaysia-based Navis Capital, which manages $450 million in the region, says “a perception of problems in one subset of the region is going to have a tarnishing effect on the whole region.”
What Went Wrong
There are several reasons for the actions by government authorities in China, Korea and Japan, which are widely seen as coming in direct response to the activities of U.S. private equity firms. Foremost among them is the fact that The Carlyle Group, Cerebrus, H&Q Asia Pacific, Lonestar Partners, Newbridge Capital, Ripplewood Holdings and Warburg Pincus have been spectacularly successful in Asia’s largest markets. Part of their success is due to the fact that these firms are smart. They see opportunities, make timely decisions, execute well and move on (exit, that is) when the time is ripe.
Part of the success of U.S. private equity firms in Asia is due to the fact that they have strong operating experience. They’ve lived through the process of buying control and reorganizing troubled businesses many times.
Another part of their success is due to the fact that the execs at these firms are pretty tough; they’ve turned the gentleman’s world of the insiders’ deal into something like a full-contact sport. For example, when local politics threatened to derail Newbridge Capital’s deal to acquire Shenzen Bank, Newbridge went to federal court in Texas. For two years Newbridge stuck to its guns. “We just kept insisting that a deal was made, that [Newbridge’s offer to buy controlling shares of Shenzen Bank] was valid and that we were going to see that the contract was carried out,” Dan Carroll, managing director of San Francisco-based Newbridge, told VCJ in an earlier interview.
And much of the success of U.S. private equity firms has been acceptable up until recently, when the dollar amounts being made on deals headed into the billions of dollars in announcement after announcement. The deals most often cited as causing Japan’s politicians to propose the regulation are two 2005 sales of equity shares in Shinsei Bank by Ripplewood, a New York-based private equity firm. Ripplewood, which acquired the bank out of receivership from the Japanese government for 121 billion, recently sold two stakes of 34% and 35% for 240 billion and 250 billion, respectively, earning a 4X ROI to date. The sore point is that it paid no taxes in Japan. One source says that the deal aroused strong anti-American sentiment in Japan because the government put large sums into Shinsei to keep its doors open.
Similarly in Korea, The Carlyle Group is noted for buying and selling Koram Bank, while Newbridge is noted for having bought and sold Korea First Bank. Both of those deals were hugely profitable.
In China, which has been struggling for years to bring its government-owned banks into a respectable and transparent operating environment, the government has been hit with repeated scandals over fraud and corruption by government employees. In the past month, high-level government officials who have been overseeing the multi-billion dollar bailouts of government-run banks have warned that the country’s domestic banking system is facing its last chance to clean up its act before China’s banking system is opened to free international competition under WTO rules. Meanwhile, private equity investment firms like Newbridge have been at the forefront to implement deals akin to those just described in Japan and Korea.
Sources in large private equity firms across Asia are divided in their opinions about the potential impact of the measures being introduced in each country at this point.
John Lewis, a managing director and 10-year veteran in Japan for JPMorgan Partners, told VCJ, “There is a lot of uncertainty regarding both the final regulatory language and how the proposed changes will be implemented. At this stage we are hopeful that the changes will not diminish the attractiveness of private equity investment in Japan.”
Another source who asked not to be named says that most countries-such as Switzerland, Germany and the United States-have tax treaties that prevent taxation on the investments by companies in those countries, so the taxes may not apply to companies domiciled in those countries.
But it is now clear from the language of the regulation passed on April 1 that Japanese authorities are serious about collecting taxes from PE firms making billions of dollars buying, improving and selling Japanese companies. Furthermore, the new regulations have as-yet-undefined conditions that may further inhibit the work of foreign private equity firms in Japan.
Carroll of Newbridge Capital was the most outspoken about these issues in an earlier interview with VCJ. He says that while the Shinsei Bank and other deals have made PE investors look like the beneficiaries at the expense of others who are in financial distress, “The Japanese proposal flies in the face of the free flow of capital and the intent of the WTO’s provisions. It’s a one-time punitive tax based in politics, and if it happens it’s a disaster. If you have to take the risks of investing in a foreign system and then you have to leave a 20% fee out of any profitable deals, it hurts investors everywhere.”
LPs with considerable buyout fund exposure or with substantial interest in commercial real estate also stand to lose a big chunk of any profits they count on in return for placing funds with risk investments. Mark Wiseman, a vice president in the private equity investment group of the $80 billion Ontario Teachers Pension Plan, says, “If we are taxed, despite being a not-for-profit, it will obviously impact our profitability.” Wiseman, who is also chairman of the International Limited Partners Association, which represents more than 150 LPs worldwide, adds that the Japanese regulation is of great concern to the LP community.
Tax regulators in Korea who were supplied with similar arguments about non-residency and with complaints about the lack of fairness in Korea’s actions, have taken an even tougher stance. The result has been the Elliot Ness-style tax enforcement actions described in the opening of this story. Tax authorities marched into U.S. PE firms looking for the proof that will allow them to declare that U.S. firms are Korean residents and thus subject to taxation. It hasn’t helped that up until December 2004 Korean domestic private equity firms were unable to invest in their own country, building a deep well of anger against the success of American firms.
China’s government regulators have signaled the end to tax-free billionaires as well. Up to now, entrepreneurs working with U.S. private equity firms have slowly created a process for making money that uses holding companies based in tax havens like the Cayman Islands or the British Virgin Islands. Richard Xu, a private equity attorney at Jingtian & Gongcheng in China, says his firm’s work is slowly grinding to a halt as investors are faced with an impenetrable regulatory situation.
Established companies like 51Job, Shanda Interactive, Sina.com and SMIC, which set up their offshore special purpose vehicles before passage of the regulation, are “grandfathered” into China and do not require approval from the State Agency for Foreign Exchange (SAFE), Xu says. But every deal in process since Jan. 24 must seek SAFE approval, he notes.
The actions against the U.S. firms were so closely timed and so narrowly directed that the counter reaction and flow of PE funds for the connected private equity community has been almost as immediate. To be certain, new Asian private equity funds continue to be raised and announced in rapid succession. But the interest in India and Southeast Asia, with their more amenable private equity environments, is on the rise. It will be revealing to see the flows of Foreign Direct Investment in the form of private equity at the end of the year. By that time it should be possible to determine if the regulations have helped the largest Asian economies that have benefited so greatly from foreign private equity investments or whether all of the negative publicity about their actions has created a capital flight to safer and more profitable investment havens.