Clash of the Appliance Titans

By LAN XINZHEN

Clash of the Appliance Titans

By LAN XINZHEN

The incarcerated founder of Gome loses his bid to oust the firm’s current chairman, bringing issues concerning family-owned public businesses to light

Even while serving out a sentence behind bars, Chinese billionaire Huang Guangyu fought for control of Gome,the appliance chain he built up in the late 1980s, but lost the high-profile war to sack current chairman, Chen Xiao. The fact that Huang remains Gome’s largest shareholder has paved the way for future power struggles over the appliance giant.

Huang’s failure to regain control of Hong Kong-listed Gome came at the special shareholders’ meeting on September 28,held to vote on key resolutions centered on the grudge between Huang and his bitter foe.Shareholders rejected Huang’s proposals to dismiss Chen and another board member close to Chen and appoint his sister, Huang Yanhong, and his corporate lawyer, Zou Xiaochun, as executive directors.

But Huang did succeed in preventing his controlling stake in Gome from being further diluted after a proposal by the Chen-led board to issue additional stock of up to 20 percent of Gome was rejected.

Another resolution to keep three directors from the Boston-based U.S. private equity firm Bain Capital, including Bain Capital’s Managing Director Jonathan Jia Zhu, was also adopted.

The spat reflects corporate governance problems, seen in a large number of China’s private companies seeking to trade their stocks on the capital market, which eventually spill into the public arena.

A grudge takes root

Before being sentenced to 14 years for bribery and insider trading last May, Huang,China’s youngest self-made billionaire, was regarded as an idol for many pioneering businesspeople.

The high school dropout founded Gome in Beijing on January 1, 1987 with a shop of less than 100 square meters selling an array of home appliances.

Just over two decades later, Gome has outlets in about 160 mainland cities, Hong Kong and Macao, and is the largest outlet for Chinese appliances.

Like many Chinese business chiefs, Huang fi lled every important position with “trustworthy” relatives or candidates from his hometown in Guangdong Province.

The retailer was listed on the Hong Kong stock market in June 2004, and had 1,141 outlets by the fi rst half of 2010, with its fi rsthalf sales revenue standing at $24.9 billion yuan ($3.7 billion).

And just as Gome has grown, so too have its rivals, including Jiangsu-based Suning Appliance, Beijing-based Dazhong Electronics, Shanghai-based Yongle (China Paradise)—of which Chen Xiao was the controller—and some foreign-funded appliance retailers, such as Best Buy.

To fuel his expansion ambition, Chen signed an agreement of Valuation Adjustment Mechanism with Morgan Stanley right after the investment bank and CDH Investments, a Chinese private equity fund, acquired a 20-percent stake in Yongle at $50 million in January 2005. Chen and his management team pledged to realize $675 million yuan ($101 million) in pro fi t by 2007. If the pro fi t was higher than the promised amount, Morgan Stanley agreed to sell certain shares to Chen—otherwise, Chen would have to sell his shares to the investment bank.

To increase performance and win against Morgan Stanley, Chen decided to forge a short-lived alliance between Yongle and Dazhong Electronics, which brought Yongle to the brink of insolvency. In a desperate search for a buyer, Chen turned to Gome. A deal was arranged. After merging Yongle with Gome in July 2006, Huang invited Chen to serve as Gome’s CEO.

After Huang’s arrest in 2008, banks refused to grant Gome additional loans, forcing Chen to introduce Bain Capital as a strategic investor to ease Gome’s cash needs. Bain Capital agreed in June that year to spend HK$1.8 billion ($232 million) buying seven-year convertible bonds from Gome at an annual interest rate of 5 percent.

But the deal hinged on a special condition: three of Gome’s board members must be from Bain Capital and removal of two of Gome’s three executive directors—Chen,Wang Junzhou and Wei Qiuli—would be seen as a breach of contract. Such a breach would entitle Bain Capital to demand Gome buy back the convertible bonds at a price 50 percent higher than Bain Capital’s purchasing price.

Huang, believing the deal threatened his control of Gome, began grumbling.He vetoed the reelection of the three Bain Capital directors in May 2010, but they were immediately reappointed in a board meeting engineered by Chen.

Chen then proposed a fi ve-year plan for Gome in July that would open 700 stores and 11 national and regional logistics bases,renovate 400 existing stores and build 11 super-large fl agship stores.

Fundraising

The ambitious plan required approximately 10 billion yuan ($1.5 billion), far exceeding the 6 billion yuan ($895.5 million)in available funds on Gome’s balance sheet.To fi nance the plan, Chen proposed another fundraiser with a target of around 7 billion yuan ($1.04 billion)—the retailer needs 3.5 billion yuan ($522.4 million) for daily operations—by issuing additional stock.

But such a fundraiser would dilute Huang’s shares from 34 percent to 28 percent, which would compromise Huang’s one third stake which guarantees him the right to veto board decisions. Huang believed the proposed fundraising was aimed to take away his control of Gome, said a manager close to Huang.

Chen’s move fanned the fl ames of Huang’s discontent and made the conflict between the two captains of industry public. On August 4, Huang demanded a special shareholders’meeting to remove Chen. The meeting was eventually held in late September.

Ahead of the meeting, the Chen-supported Bain Capital converted its HK$1.8 billion ($232 million) bondholding in Gome into a 9.98-percent equity stake, becoming the second-largest shareholder of Gome and diluting Huang’s holding in the company from 34 percent to 32.47 percent on September 15.

The plan to issue more stocks was scrapped at the September 28 meeting, and Huang remains the largest Gome shareholder with his 32.47-percent stake. Chen has also retained his position as the chairman of Gome.

So far, the damage appears limited, but that might not last if Huang holds true to his threat to sell about 400 Gome stores he privately owns, a move that would drasticallyreduce Gome’s income and competitiveness.

CONTROVERSIAL GOME: On September 30, Gome employees make preparations before opening a flagship store in Hong Kong

Gome “has strayed from the path of profitable growth, resulting in deteriorating core competency and losing its industry leadership,” said the statement fi led by Huang’s family after the meeting.

It also said, “Nothing has changed about our concerns regarding the unrepresentative nature of the board, and we reserve all our rights to take appropriate action to protect our interest and that of other shareholders.’’

Gome’s shares have declined 15 percent this year, against a more than 2-percent gain in the benchmark Hang Seng Index. Its closest and larger rival, Shenzhen-listed Suning Appliance,has gained about 16 percent in the same period and about 60 percent since mid-May.

Future of family businesses

Gome’s first-half profit rose 66 percent to 962.3 million yuan ($143.6 million) from a year earlier, as Gome closed unprofitable outlets.However, Huang claimed the store closures came at the cost of losing market share. Still, the gains were better than that of Suning Appliance,which reported a 53.3-percent year-on-year rise in fi rst-half net pro fi t to 2.6 billion yuan ($388 million) from its 1,075 outlets.

The conflict between Gome’s founder and top executive raises the question: How can China’s family-run businesses effectively implement modern corporate governance during the country’s economic transition when a growing number of private companies strive to go public?

Traditionally, founders of most of China’s private companies run the businesses on their own and become the largest shareholders of their listed companies. Conflicts tend to arise when they hand over part of the controlling power to the board, which answers to shareholders.

The Chinese version ofForbes,in a September 14 survey, said that the chiefs of China’s family businesses had misgivings over the possibility of losing control of their firms in private equity fundraising and were prudent about such practices.

The survey also found more than 40 percent of first-generation entrepreneurs of non-public companies were prepared for entrusting professional business executives instead of their children with ensuring sustainable development of their businesses. Only 13.7 percent of the respondents demanded that their children be the sole executives of their family businesses.

Based on the annual fi nancial reports of Chinese listed companies in 2009, theForbessurvey found 35 percent, or 115 of the 305 listed family businesses now employ professional managers for positions such as general manager, president and CEO.

Potential conflicts

But it’s also a fact that the board of directors in many companies serves a somewhat puppetlike role. Founders or the founding families still have the fi nal say in deciding issues vital to the development of these businesses.

Under such circumstances, con fl icts between founders and business executives will eventually break out. Gome stands out as the fi rst of such cases.

The vote at Gome’s special shareholders’ meeting is “historic,” which “could be a vote on whether China’s private companies should practice corporate governance,”said Zhou Jiangong, Editor in Chief of the Chinese version ofForbes, in his blog.

Family businesses must be transformed into modern corporations, and China’s enterprises need excellent professional managers, Zhou said.

The Chinese traditionally view professional managers as housekeepers and value most loyalty. But loyalty to professional managers, while de fi ned within the context of modern corporate system, means honesty and trustworthiness for all shareholders, not just one family, he said.

Problems will continue to emerge concerning the management of private companies in China because of the absence of suf fi cient legal guarantees, but “we need to be patient and tolerant, allowing family businesses time to complete the transition and become competent public companies,” said Han Zhaohua, a researcher with the Institute of Economics under the Chinese Academy of Social Sciences.