Delong and the short of it

Last month China's state media began reporting that Xinjiang Delong, a private sector conglomerate run by Tang Wanli may have misappropriated at least Rmb6 billion ($725 million) in funds. The fall-out has compromised China's already battered stockmarket and raises at least two major questions about the nature of the Chinese private sector. The first question is whether private companies automatically have better and more efficient growth prospects than the state sector. The second concerns the accuracy of a popular assumption that private companies cannot easily access financing.

Many Western observers see the emergence of the private sector as a reassuring imitation of Western economic evolution. Chinese investors tend to be more cautious.

The private sector in China is dominated by families and close friends - not by professional managers or institutional investors as in the West. Families are possibly the strongest units within Chinese society, so local investors view them with a great deal of caution.

For example, prior to the recent IPO of sports apparel company Li Ning mainland observers were focused on the thoroughness of the clear-out of the founder's family members. Founder Li Ning re-structured his organization in the late 1990s and threw out most of his own clan from executive positions, although the family's controlling stake still attracts negative comments in the local media.

If you look at which companies mainland institutional investors follow it is clear they regard state-owned companies such as steel and telecom companies and the power companies as more reliable areas to park their money.

The same was supposedly valid for banks, which had a reputation for preferring to lend to the biggest state-owned companies, both for the implicit government guarantee and because they are considered too big to fail.

Yet the Delong case clearly shows that private companies can access cash by a variety of means.

In fact, the bulk of its financing came from banks, through the loan guarantee system.

Delong, which focused M&A to grow at a prodigious rate, raised enormous sums through debt incurred by its own listed companies, debt from other listed companies and when that was still not enough, it captured banks and securities houses.

Delong has used these three source for most of the past decade, and only recently has it come under the spotlight.

Only in March this year did reports start emerging in the mainland press about the opaque nature of the company's growth financing.

Delong hit its stride in 1996 when it took stakes in several A-share listed companies and propelled their share prices to unprecedented highs. It now has stakes in five listed companies and 177 subsidiaries across a score of industries. But with billions of Rmb missing from its balance sheet, fears the disaster could spread is dragging down the whole stock market because of the network of loans and loan guarantees the company is involved in. Official state media say Delong has been involved in loans and loan guarantees with 40 listed companies and many more that number of unlisted companies. The five listed companies in which Delong has stakes have seen their share prices fall by an average of 40%, but it is suspected many other companies are exposed to the failing giant. So far, on top of the Rmb4 billion siphoned off from the listed companies, another 19 companies have seen Rmb20 billion wiped off their share price as a result of their exposure to Delong. But with the story still unraveling, it is almost impossible to put a value on the amount of money that has been lost, wasted or embezzled.

At its worst, instead of providing better quality growth than state companies, Delong seems to have been another example of a pyramid scheme supported by fictitious hyper-growth. Just like Yang Bin's Hong Kong-listed Euro-Asia's two years ago, the model was based on a 'flucht nach vorne' the German expression for 'flight to the front'. The model works by announcing increasingly spectacular deals or acquisitions to fool investors the company is growing. Details are withheld from investors (one newspaper report estimated that not more than 5 people knew the exact financial circumstance of Delong), so they rely on the prestige and high profile the company has achieved, as well as the network of accomplice officials it has built up, as an indicator of the company's strength.

The problem with this model is that the company must keep on trumping itself, as any slow down in momentum will cause investors to look more carefully at the company.

Yang Bing eventually overreached himself when, outrageously, he got himself declared CEO of a North Korean special economic zone.

In Delong's case, cannier investors say they began to wonder about the state of the company's cash flow when it began to gobble up investment trusts, commercial banks and securities houses. The company started in 1997 with a Xinjiang leasing company, but expanded to taking stakes in Xiament United Trust, Jinxin Trust, Zhongfu Securities, Jianqiao Securities, Deheng Securities and Hengxin Securities as well as city commercial banks.

"It's a bit like the joke about why the criminal robs banks, and he replies: Because that's where the money is. That's what the likes of Delong have also realized," says one observer.

Delong's model was possibly exacerbated by the lack of risk management techniques, such that the company was paying far too much for its capital because its cash needs were so great.

At one point, the company was borrowing money from grey market and private sources at interest rates of up to 20% per year, when one-year bank lending rates are around 5%.

The company has always prioritized the search for cash, to the extent that managers were rewarded for raising funds according to quotas as much as for managing their departments. In addition, special teams of fund raisers were set up to explore avenues for fund raising.

Delong needed cash for three reasons. The first was acquiring new companies with their assets and cash flows to convince investors it was indeed a company following the GE growth mode through M&A. The second was the cash needed to manipulate its share price so investors would be tempted to get on the band wagon, thereby increasing the value of the shares it used as collateral with other lending institutions and to encourage other companies to provide loan guarantees. A final reason was to maintain its status by throwing around cash on the all-important perks of the super rich in China.

Delong got the bulk of its funding via loan guarantees from both affiliated companies and independent companies. It is because the extent of the loan guarantees to Delong is unclear that the markets have been so spooked. That a private company got loan guarantees is quite unusual and is best explained by the numerous assets it could mortgage. That of course stimulated the company to keep accumulating assets, creating a classic vicious circle. Loan guarantees are a controversial topic in China, which generally benefit SOEs.

A provincial SOE can, for example, get a guarantee from its Beijing parent, higher up the bureaucratic ladder. Private companies, says one local businessman, have to rely on paying high fees for the guarantee or more commonly by paying or bribing fellow executives.

The most important question about Delong is whether it was simply a criminal organization.

If it were, there would be no lessons to be drawn from it, since it would presumably be an exception.

But one Haitong Securities analyst recently advanced the opinion the company was basically sound, but had overreached itself.

Other say that the company's problem was management, especially risk management.

Had these problems been less extreme and if Delong had not lost its ability to repay its creditors, it is possible there would have bee no need for its high-risk fund raising techniques to come to light.

Perhaps Delong's mixture of aggressive expansion, cash guzzling and questionable legal behaviour is simply a reminder that China's economy is developing according to its own rules and logic. That means writing about China according to familiar Western concepts of private ownership versus public ownership, efficiency versus waste and legality versus illegality is more of an attempt to make China accessible via familiar concepts rather than an accurate reflection of what's actually going on: something far more short-termist, high risk and contemptuous of definitions.