Carlyle Buys Xugong: Smart Move, or Longshot?

Hutongwise
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Carlyle Group to Acquire 85% of Chinese Construction Firm by Laura Santini, The Wall Street Journal, October 25, 2005, Page C5

American private equity monster The Carlyle Group has tossed US$375 million into purchasing Chinese construction machinery manufacturer Xugong Group Construction Machinery. Leaving aside the potentially ugly issues surrounding The Carlyle Group and it’s alleged links to the pocketbooks of some very, very big people in the U.S. government, it’s quite possible that Carlyle has made a really smart move by making this investment.

It’s also possible they’ve stepped into some serious elephant spoor.

The calculus looks good. China is in a spasm of construction and there are local shortages of construction equipment. The world is looking for cheaper machinery, and it’s probably only a matter of time before Kubota, Caterpillar, Komatsu, and the whole lot turn into design and marketing houses, outsourcing all of their manufacturing to companies like Xugong.

But that could wind up as so much happy-talk. Consider:

• China’s construction boom is a fragile thing. It could end at any time, undercut by a capital shortage (real or created by the government), skyrocketing costs for materials, water and power supplies, or a simple government ban on new construction out of concern that the sector is leading the entire economy to overheat.

• Exporting is not easy. Xugong does little of it now, and exporting tractors is not like exporting underwear. Dealer networks need to be established, dealers must be trained, repair facilities established, spare parts supply chains developed, owners manuals, repair manuals, parts lists translated into each required language. All while hoping that the world economy holds together, that export receivables don’t fly out of control, and that Komatsu or Cat doesn’t get a second wind and take away all of the profitable business, leaving Xugong with the low-margin stuff.

• Komatsu and Cat might outsource to Xugong et al. Or they might build their own, state-of-the-art factories in China. Either way, there is no telling when Xugong might pick up this windfall, if ever.

Interesting that Caterpillar and JP Morgan lost out the bidding war for Xugong against Carlyle. Cat has been dancing around with Xugong for years, and arguably knows where the value is in the organization, and their bid came up short. Carlyle has some capable investment bankers (they pulled the China Pacific Life deal – a smart investment – out of a tough stalemate), but common sense suggests the Boys from Peoria probably know their business better than the suits in Washington and Beijing.

There’s also a lot of private equity in China chasing very few deals. I would not be surprised if at some point in the future it came out that Carlyle, feeling the heat of JP Morgan in the deal, was a bit more aggressive than the fundamentals dictated. That would hardly be a first in China.

I may well be wrong, but I’d bet Carlyle left some money on the table. Either way, Xugong is going to take a lot of work – and the economic stars staying aligned – (or a pretty big sucker) to pay off for Carlyle.