GOME’s stock was suspended on Nov. 24 after reports that ex-chairman, founder and top shareholder Huang Guangyu was under investigation for alleged financial irregularities.
Why would a private equity firm take such a gamble? Not only is Huang — one of China’s richest and best connected businessmen — under investigation, but he disappeared last November and has not been seen since. The new chairman says that he does not know where Huang is.
The answer is that it’s a calculated gamble. Bain and other private equity firms pursued the retailer because GOME Electrical Appliances, known as China’s Best Buy, has a lot of potential despite its recent difficulties, which also include a liquidity squeeze.
It is a play on the rising spending power of China’s emerging middle-class. GOME is the trusted low-price vendor for things like digital cameras and flat-screen TVs as its retail network, the largest in China, gives it massive pricing power.
Foreign investors aren’t popular in China now because they are perceived to have made a lot of money from stakes in local banks without doing much to earn it. This means opportunities to buy good-sized assets are few and far between.
Just to get a shot at GOME, Bain Capital had to go through a competitive auction. And one of the reasons it was selected over rival bidders,
Bain Capital has structured the deal carefully to protect itself. Of the up to $447 million it is investing, $233 million is in the form of a seven-year convertible bond which they can put back on GOME after five years. Those convertibles’ exercise price is about 40 percent below GOME’s Thursday close. The shares are convertible a month after they are issued.
Bain Capital is putting up the rest of the money by underwriting a new share offering that will be offered back to GOME’s own shareholders. Huang as a shareholder will have the right to subscribe to the offering, but his assets might have been frozen by the government.
Even after the big run-up on Tuesday, GOME is trading at about 12 times next year’s earnings, lower than its smaller rival Suning Appliance’s valuation of 28 times. But GOME is cheap for a reason.
Years of overexpansion have led to thin margins and dozens of loss-making stores. It is hard to argue that the brand has not been tarnished by Huang’s disappearance, and the bank’s unwillingness to extend further credit. The damage could be seen in the first quarter when GOME’s profit fell 37 percent while sales contracted 20 percent.
Top managers at China’s state-owned banks routinely play musical chairs and can be investigated without raising eyebrows, with stock prices barely moving on the news. But GOME is a private company, and Huang almost has a godfather status.
After the deal with Bain Capital and rights issue, GOME should have no near-term liquidity worries, but big challenges remain for Bain Capital. Private equity firms usually make money by sending capable managers who turn around the business quickly, but in this case Bain Capital is reliant on GOME’s management.
The new team is not related to Huang, but the ex-chairman still looms large through his majority holding and the plan to transfer more than 400 stores from the unlisted parent company, which he wholly owns, to the listed company by 2011.
True, Bain Capital will be entitled to three non-executive positions on the board, but that won’t give it management control. Bain Capital may be willing to take the risk because its China head Jonathan Zhu has been eager to pull off a big deal since he joined two years ago from Morgan Stanley where he was country head.
This investment may yield a big reward. But by no stretch of the imagination can it be called riskless. In a more difficult environment, with credit still constrained in western countries, it suggests that getting into China is a high priority for private equity firms.
By Wei Gu
Wei Gu is a Reuters columnist. The opinions expressed are her own. At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund.