PWC China

The Misfortunes of the Big Four in China

1 Comment / January 29, 2014

China First Capital blog–

Last week, an SEC judge in the US delivered a spanking to the Big Four accounting firms, barring their Chinese affiliates for six months from doing audit work for US-quoted Chinese companies. “To the extent [the Big Four] found themselves between a rock and a hard place,” the judge’s decision declares, “it is because they wanted to be there. A good faith effort to obey the law means a good faith effort to obey all law, not just the law that one wishes to follow.”

Overall, the judge’s 112-page ruling on the audit work of the Big Four in China makes for interesting, and at times damning, reading. You can click here to access it.The judge’s decision should probably be required reading for anyone working in Chinese private equity and capital markets transactions with Chinese companies. Investments in Chinese companies worth many tens of billions of dollars rely, at least to some extent, on the accuracy and reliability of Big Four audits. That audit bedrock looks shakier now than it did a week ago.

The Big Four are appealing the decision meaning that for now at least, they can continue to serve their US-listed Chinese clients, continue to audit their accounts, and continue to earn sizable fees for doing so. If they lose the appeal, they will need to suspend for six months their main activity in China. The Big Four have a near-monopoly on audit work for the over 160 Chinese companies listed in the US. Will their Chinese clients permanently go elsewhere? What about the 15,000 people working for the Big Four in China? How will the firms pay them during the half-year suspension? How will they spend their working days if not engaged in audit work?

This much is clear: whatever happens with the appeal, the reputation and trustworthiness of the Big Four’s work in China has taken a recent beating. The judge’s decision last week is particularly ill-timed. Chinese companies have only just regained some of the lost trust of US investors, allowing IPOs to resume. I have friends at all Big Four firms, and have worked with all of them over the last six years in China.

This dispute between the SEC and the Big Four has been bubbling away for over two years. It was triggered by a series of SEC investigations into serious misbehavior by some Chinese companies then-quoted in the US — fraudulent financial accounts, incomplete disclosure, faked revenues. The companies were punished, and their shares delisted from the US stock exchange. But, what about the Big Four auditors? Why hadn’t they uncovered and reported their clients’ misconduct to the SEC? Were the Big Four in China careless?  Negligent? Or even complicit in these Chinese companies’ attempts to mislead US investors?

This quickly became a focus of the SEC investigation. To determine if the Big Four audits were performed thoroughly and in compliance with US securities laws, the SEC asked the Big Four in China for their audit papers — that is, the complete written documentation showing what they did and with what level of diligence and accuracy. The Big Four refused the SEC requests to hand over the audit papers, saying that to do so would violate Chinese state secrecy laws.

They used the same argument with the judge. He rejected it outright. Instead, he says the Big Four demonstrated “gall” in “flouting” the SEC, were “oblivious” to some core legal issues, and took a “calculated risk” they wouldn’t get punished. Strong stuff. While the judge doesn’t say directly that greed was a major factor in the Big Four’s decision to disobey SEC orders, but it may be fair to make that inference. Their strategy seems basically having one’s cake and eating it too. They wanted to keep earning big fees for China audit work, while not fully complying with US securities laws. In specific cases cited by the judge, accounting fraud at US-listed Chinese companies was first brought to light by short-sellers, rather than by the Big Four audits.

The judge’s ruling notes the fact that over the last decade, the Big Four have built very large businesses in China. KPMG China and Ernst & Young China both tripled in size from 2004-2012. PWC grew fastest, increasing its staff four-fold to over 8,000 people. Such rapid growth is unprecedented as far as I know in the history of large accounting firms.

One large irony here is that the Big Four are accused by the judge of violating Sarbanes-Oxley. That law has overall been very good to the Big Four, since it gave accountants increased responsibility to police US-listed companies’ financial accounts. The scope of audits increased and with it the fees. But, when things go wrong, as they have with quite a number of Chinese quoted companies listed in the US, the auditors can potentially be held legally liable.

The Big Four all argued to the judge they should be treated leniently because if banned, no other accountants in China have the training and professionalism to do audit work that meets SEC standards for investor protection.  Any Chinese company that can’t find a new auditor would need to delist from the US stock exchanges. The judge dismissed this argument, and helpfully lists a group of five other accounting firms that have done audits in China and, unlike the Big Four, turned over audit papers to the SEC when asked.

Some big US multinationals including P&G, Amazon.com, Apple, The Coca-Cola Company and Nike, with large revenues and operations in China, would probably also need to find new Chinese auditors if the ban is upheld. Investing or operating a US-owned business in China, never easy, will become even trickier if the Big Four are forced to down pencils in China and serve the six-month SEC suspension.

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More Trouble for the Big Four Accountants in China: Pushing Prudent Analysis or Propaganda?

Leave a Comment / March 18, 2013

This is not a good time for the Big Four accounting firms in China. The SEC has charged them with breaking securities law, while one of the group, Deloitte, is now in serious hot water in the US, facing a shareholder class action in Delaware for aiding a US-listed Chinese company in defrauding US investors. If Deloitte loses, or opts to settle, it could uncork a tidal wave of copycat claims that would do serious, perhaps irreparable damage to the China business of Deloitte, and then also possibly to Ernst & Yong, Price WaterhouseCoopers and KPMG.

The charges against the Big Four all boil down to allegations they were either negligent in fulfilling their statutory duties, or in cahoots with bad guys scheming to defraud US investors. The implication of the SEC charges seems to be the accountants’ willy-nilly pursuit of fees led the Big Four to cut corners, surrender objectivity, and allow their judgment to become corrupted.

Similar doubts can be raised about the quality, credibility and soundness of the judgments the accountants provide in assessing China’s private equity industry. Even as the PE market began to slide into serious trouble last year, the accountants kept talking up the industry. In particular, it’s worth reading the two big and well-publicized reports on China private equity produced by Ernst & Young  and PWC. Both can be downloaded by clicking here. E&Y Report. PWC Report.

Both of these documents were published in late December 2012. All IPO activity for Chinese companies had come to an abrupt halt months earlier, and along with this, China’s PE firms basically went into hibernation, closing off almost all new investment in China. The situation has, if anything, worsened so far in 2013. And yet, to read these reports, my opinion would be that that everything was overall pretty rosy.

Nowhere is it mentioned that a main factor contributing to the collapse of Chinese IPOs is the widespread loss of confidence in the work of accountants. While the PWC report does note the challenge posed by limited exits, it echoes the generally bullish sentiment of the E&Y report. PWC confidently predicts, “We think new deal and exit activity will accelerate strongly from 2Q13 as pricing expectations adjust.” In other words, according to PWC, we’re weeks away now from not just the revival of the comatose China PE industry, it’s going to leap out of bed and begin doing wind-sprints.

Let’s see how things play out.  But, the greater likelihood in my opinion is that 2013 will be the worst year in recent history for China PE. Further out, things look even more dire, as hundreds of PE funds reach the end of their lives still holding tens of billions of dollars in illiquid investments made with LP money.

Why then all the optimism, the boosterism, the cheerleading from the accountants? I have a lot of respect for their professionalism. To me, it seems that their enthusiasm may be more a matter of  wishing, hoping and urging that the PE industry, and the fees that come from it, continue to grow. To crib a line from Warren Buffett’s latest Letter to Shareholders, “wishing makes dreams come true only in Disney movies; it’s poison in business.”

China PE has been good — no, make that, very good — to the Big Four accounting firms. It’s anybody’s guess, but I’d estimate the total fees earned as recently as 2011 by the Big Four for work done for PE firms in China is well above $75mn. This is for audits of existing and potential investments, for other due diligence services and for portfolio valuation.

PE firms are certainly one of the key sources of revenue for the Big Four in China. The Big Four also do work for Chinese corporations, but that market is much more crowded in China, with thousands of local accounting firms also getting their share of corporate audits and tax. The local firms charge about half what the Big Four do. The global PE firms rely almost exclusively on the Big Four to do all their work in China. The PE firms pay top dollar.

The Big Four get paid big money to do audits and projections on many of the deals the bigger PE firms are considering in China.  Very often during due diligence the PE firm opts to abandon a deal. Even when they do, the accounting firms get paid in full. At around $250,000 a pop, the financial DD package on PE deals that never close has become a very lucrative line of business. I’ve also known of cases where the PE firm paid for the audit and projections but then tossed them away after deciding the conclusions were flawed.

Reading the E&Y and PWC reports, it seems to me a primary purpose was marketing, to let the PE industry in China feel good about itself, to reassure distant LPs, and even to encourage China GPs to be a little more bold and active. Nowhere does one read any kind of more sober analysis pointing to the systemic problems in the industry caused by the enormous overhang of unexited deals, expiring fund life, the damage done to IPO markets by false accounting, the billions of dollars in LP money at risk. The reports seem more like propaganda than a prudent assessment.

It’s also puzzling that the accounting companies shared no serious research on the scale of the problem of unexited deals in China. Self-interest, as well as professional credibility,  would seem to dictate it.  Instead, it was my company, which earns fees of precisely zero from PE firms, that made the effort over six months to research and contextualize the problem of unexited deals in China. We had no financial incentive to do this work, but did so because we thought it’s the best way to put the China PE industry on a sounder long-term footing and get PEs to start again making new investments.

It’s not only the accountants that have been gorging on PE firm fees. The big US and UK law firms, management consultants like McKinsey, market research firms and placement agents have also been earning very fat fees and retainers from China’s PE business. My guess is the total amount of LP wealth transferred by China PE firms to professional services firms is above $250mn a year. None of these firms issued serious public warnings to their PE clients about problems bedeviling the industry. McKinsey, which interviews GPs, offered this in the 2012 report I saw on private equity in China, ” As one large GP in China told us, “We’re busier than we have been in the last eight or nine years.”

I can’t help but feel that all these professional services firms have perhaps gotten a little drunk and maybe a little lazy from all the easy money they’ve been earning from China-focused PE funds. No one wants to say anything that might close down the tap on the billions of new LP money coming into China each year, a meaningful slice of which always gets divided among these professional service firms. And so the rather utopian portrayals of China PE keep getting printed and circulated.

It’s similar to the way equity analysts at brokerage houses never seem to have a bad word to say about the companies their firms do business with. Even when an analyst decides the company is a loser, the published research will merely advise to “Hold” or “Accumulate”. In the head-to-head combat between a revenue stream and forthright assessment, the revenue stream always seems to win.

 

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