Privatization Crash for a High-Flying Airline

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(Caixin Online) Five years ago, a little-known businessman named Li Zeyuan burst into the major airline business by outbidding China's flag carrier for a 65 percent stake in Shenzhen Airlines Co. Ltd.

Air China had offered a respectable 1.8 billion yuan for the stake being sold by Guangdong Development Bank. But Li's Shenzhen Huirun Investment Co. trounced the nation's flagship carrier with a winning bid of 2.7 billion yuan.

The deal, with money Li borrowed from New China Life Insurance,  set a new record for a privatization of state-owned assets.

Li catapulted to fame. But the private takeover tormented state-owned Air China, Shenzhen Airlines' No. 2 stakeholder with a 25 percent share. No less disappointed was the main government shareholder, the Shenzhen Municipality.

Since November, though, the tables have turned. Li as well as former Shenzhen Airlines President Li Kun have been jailed on suspicion of financial fraud. In addition, Li's friend and former head of New China Life, Guan Guoliang, has stood trial.

And the once red-faced Air China has taken over the cockpit after agreeing to inject 682 million yuan into Shenzhen Airlines and raising its stake to a controlling 51 percent.

Air China announced the takeover March 21 following talks with the Shenzhen government and remaining officers at Huirun who, following the arrests, accepted a share dilution plan cutting the private investor's stake to 24 percent. City officials, meanwhile, agreed that city-controlled Total Logistics (Shenzhen) Co. would inject 348 million yuan to boost its stake to 25 percent from 10 percent.

As the dust settles, Air China is finally getting what it sought before Li got in the way: A better grip on a lucrative airline market in rapidly growing southeastern China.

Fast Takeoff

Li oversaw a rapid expansion at Shenzhen Airlines, which is now China's fifth-largest carrier and flies more than 200 domestic and international routes. After the privatization, company assets climbed to 24 billion yuan from 4.4 billion yuan, and the fleet grew to 134 aircraft from a mere 27.

Shenzhen Airlines also went on a hiring spree under Li, raising employment to more than 14,000 today from just 4,000 in 2006.

The expansion started immediately after Li outbid Air China with his ambitious "Plan 369," which called for building the fleet to 100 aircraft and linking 10 hubs in six years. The goal was to build Shenzhen Airlines into a first-class, international carrier by 2015.

Since the plan required buying and leasing aircraft, Shenzhen Airlines soon cut a deal with the Irish budget carrier Ryanair and a company controlled by Li business associate Liu Wenbiao called Northwest Leasing.

Rynair agreed to sell five of its retired Boeing aircraft to Northwest for US$ 150 million. Northwest said it would restore and lease the aircraft to Shenzhen Airlines by late 2007. Similar agreements were later signed for another 12 aircraft formerly flown by Ryanair, bringing the combined value of the purchase and lease deals to about 2 billion yuan.

Not until later did audits of Shenzhen Airlines uncover a trail of deception that eventually led to Li's demise.

An airline employee familiar with the aircraft leasing process told Caixin none of the five aircraft in the first Ryanair batch were delivered to Shenzhen Airlines. In addition, a source familiar with the case told Caixin that investigators found Li transferred 1 billion yuan from Shenzhen Airlines to Northwest Leasing, which eventually became a business arm of the airline.

Investigators say the transferred funds were not used for buying aircraft. Rather, they say, Li exchanged the yuan and transferred about US$150 million abroad.

An investment banking source claimed Li never intended to expand the airline's business but simply used the carrier as a cash-raising platform. Another source said Li also hoped to cancel out Shenzhen Airlines' debt by arranging a Northwest bankruptcy after the 1 billion yuan transfer.

Li's airline borrowed about 10 billion yuan from various banks in the name of developing new carrier hubs. But after money was channeled to Shenzhen Airlines Real Estate Co., the projects evaporated.

Caught Red-Handed

Eventually, minority shareholder Air China caught on to the schemes. Auditors found Shenzhen Airlines smothered in debt, with liabilities exceeding assets, a source said. Phony aircraft leasing contracts were used to obtain bank loans that were then used to repay debts from Li's initial purchase of the airline.

An audit by Air China is expected to determine whether the company inflated profits. A source participating in the audit said Shenzhen Airlines' financial situation is bleak, with the company close to insolvent.

A key factor in Li's temporary success was image-building. He made friends with New China Life's Guan, who ponied up most of the money needed to buy the airline. He also won the confidence of bankers who counted on for a stable capital chain.

Li traveled extensively to promote the airlines' expansion strategy. Media reports indicate he visited 11 provinces beginning in July 2008, powwowing with senior local government officials at every stop.

A source close to the airline said Li leveraged local needs for economic development by promising to provide new air links. This won the airline access to subsidies and preferential treatment from local governments. Eventually, the airline's offices and real estate interests spread to 20 cities.

The source said local governments generally provided free land for the airline's infrastructure projects. Li would set aside 20 percent of this land for the airline and dedicate the rest for real estate developments which, he hoped, would turn into cash cows.

A source close to the audit said real estate obtained by the airline was rarely recorded on the books. Instead, it was held by Shenzhen Real Estate, which Li established in 2006 with registered capital of 100 million yuan. Huirun held 70 percent of the company, while the airline – which was tapped for real estate deal cash – controlled the rest.

"Before Li Zeyuan's acquisition, Shenzhen Airlines was a good company," lamented an Air China source. "It had posted 11 consecutive years of profits. Even during downturns for the air transport industry, when other airlines were posting losses, Shenzhen Airlines remained profitable."

From an asset-liability ratio perspective, Li's privatization devastated Shenzhen Airlines. Air China reports said the airline's debt ratio climbed from 87.29 percent in 2007 to 96.58 percent by June 2009 – relatively heavy liability for an air carrier.

As debt rose, banks tightened. A Shenzhen Airlines insider said the airline began leasing aircraft and selling what it owned. The airline also asked the Shenzhen government for guaranteed loans, and at times demanded subsidies to relieve urgent funding gaps.

After donating 340 million yuan for Sichuan earthquake relief in 2008, for example, the airline asked the Guangdong Province government for an equal amount in subsidies. It also asked the Shenzhen government to back billions of dollars in loans. And a government source said the airline asked the government to provide 800 million yuan in discounts on loan interest rates.

None of these requests for government support were approved. But Li considered the government his lender of last resort.

"Li Zeyuan once said that when no banks would give him loans, the government had to think of a way to help," said one source.

The airline also tried all sorts of private financing options, including foreign bonds, the source said, even attempting private placements in 2008. "None was successful," the source said.

Public security agents moved in last November, arresting Li. The privatization tycoon is being investigated for alleged financial crimes.

Li Kun, the former Shenzhen Airlines president, was taken away March 6 on similar charges.

Investigators are looking at the money trail left by Li's deals, some of which apparently lead to overseas accounts. But one source admitted, "The question is how much can be gotten back."

Meanwhile, Air China is mapping out a new financial trail. The carrier said in its recent statement that a Shenzhen court has accepted a creditors' application for the liquidation of Li's stake in Huirun.

Eventually, a source said, the investment firm may have to transfer its now-minority stake in Shenzhen Airlines to a city government enterprise, marking an absolute dead end for Li's failed privatization.
 
"Li Zeyuan was too bold," a source said. "Sooner or later, he had to get into trouble."

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