Power Struggle and No Quiet on the Gome Front

The complexity of the corporate strife roiling retail giant Gome Electrical Appliances Holdings Ltd. has gone beyond anyone's expectations, or even imagination.

The latest quake came August 4 when the company's largest shareholder Huang Guangyu demanded in a poignant letter that the Hong Kong-listed company call a special shareholders meeting to vote on his proposal to remove Chairman Chen Xiao.

The Chen camp immediately launched a defense that focused on his most pressing need – to garner enough votes from institutional investor before shareholders gather, as per Huang's demand, September 28. They need at least 19 percent of the shareholder votes to reject Huang's proposal.

Huang and his supporters are also trying to win over institutional investors. Moreover, they also need cash as a tool for a retaliation move against a possible dilution of their stakes through a threatened private placement.

Each side claims it has enough support from institutional investors, but neither is assured of victory. A Huang representative admitted as much to reporters when he said recently "the stand of institutional investors is still unclear."

Meanwhile, Gome's share price has been plunging, losing as much as 20 percent of value in recent weeks. Indeed, the negative effects of the internal power struggle at Gome are deepening.

War Chest

Cash is Huang's greatest challenge. Caixin has learned that the main assets for Huang's camp, which includes some of his relatives, include real estate investment companies Eagle Investment and Peng Thai Investment, and more than 350 retail stores that carry the Gome name but are not controlled by the listed company.

"Should Huang emerge as the victor, he might inject the unlisted companies into the listed company so as to increase his stake," said a Gome investor who is closely following the row. "His shareholding would then increase by approximately 20 percent."

A Huang family representative told Caixin it was working hard to sell Eagle's assets, but that the task was difficult because they had little time. He also disclosed that Eagle sold the Jianguo Hotel in Beijing in February 2009, declining to reveal the price, although another source said it was above 200 million yuan. Meanwhile, the family is in the process of trying to raise cash by disposing of Gome Shopping Mall in Beijing.

A fund manager for private equity investments was quoted by China Securities Journal on August 18 as saying that the family had raised close to 2 billion yuan. In addition, rumors have circulated that Huang has won financial backing from Zhang Dazhong, founder of the retail chain Dazhong Electronics, which is acquired by Gome in December 2007. Zhang reportedly agreed to provide "hundreds of millions yuan" loan with free interest in the first year.

Growing Resentment

How did the Huang-Chen relationship sour? An investment banking source familiar with the unhappy shareholder, who has been jailed since May following a financial fraud conviction, said it began when the U.S.-based private investment fund Bain Capital entered the picture.

When Bain and Gome began courting in 2009, Huang did not object to the firm's plan to invest. He even promised in writing not to participate in a related share rights issue. It's also important to note that he was, at that time, being detained by police while awaiting trial.

The source said that what really drew Huang's displeasure were some specific terms for Bain's investment. One demand was that Gome would have to pay 2.4 billion yuan in compensation to Bain if the investor's nominees failed to enter Gome's board of directors.

According to Chen, the investor wanted more than a single seat. "Bain agreed not to dilute shares, and we accomplished that," he said. "But Bain Capital also attached conditions to it with respect to the running of the company and its transparency, such as a request for three seats on the board of directors."

The Huang clan representative, however, said Chen's claim about three board members has not been substantiated.

Another source tried to shed light on the rift. "Before Bain Capital came on board, the Huang clan came to have some understanding of the situation through other channels," the source said. "They expressed doubts about issues such as tying the deal to incentives for senior executives, the number of directors to be named by Bain Capital, and default clauses.

"However, their objections were not accepted," he said. "They knew about the specific clauses only after they were announced officially."

A source close to Bain told Caixin the investor thought Huang had agreed to the deal, although he was not sure about the extent of Huang's knowledge of details.

"At that time, Huang had to choose between giving up his controlling stake and accepting Bain Capital, and he was compelled to choose the latter," the investment banking source said. "However, it's likely he was only aware of the basic terms of financing and not compensation clauses."

"Perhaps he only saw specific clauses after the deal was inked. He also had issues with the stock option incentive" sought by senior executives. "He wanted the incentive to be awarded gradually, but they (Gome) awarded it in one go."

Chen says differing explanations about Bain's offer stem from the fact that Huang was in jail during the negotiation period and didn't get all investment-related documents. Furthermore, there was no obligation to share every detail with Huang, since he was not a member of the board.

Dilution Debate

In the run-up to the September shareholders' meeting, Gome's plans for a possible private placement grew ambiguous.

If additional shares representing 20 percent of Gome's outstanding listed shares are issued, for example, Huang's stake would be diluted to less than 25 percent. He has consistently aimed for at least 30 percent so that, based on Hong Kong securities rules, he can retain the right to make a tender offer. Also, Huang has seemed bent on keeping one-third of the votes.

A source close to Gome management said company executives were discussing the possibility of a private placement. The listed company's total equity is about 15 billion shares, and if the board issues another 20 percent by invoking the general mandate, another 4 billion shares would be issued.

Assuming a discount of less than 5 percent on Gome's closing price of HK$ 2.34 on August 19, the placement would raise more than HK$ 8 billion. Due to share price volatility, however, it would be challenging to achieve a financing level of this magnitude in such a short period.

A source close to Bain said investors have questioned the need for a stock placement, and the board has delayed a decision

"How can there be a placement just to fight a battle?" the source said. "There is no reason why there cannot be a placement, and a placement of 10 percent to Bain Capital is even further from the truth. "

Some say Huang might try to increase his stake through a deal on the over-the-counter market, but the family representative discounted that option as too costly.

Regardless of who wins, Gome as a business has suffered. Analysts say company earnings will be negatively affected, at least in the short term, during the power struggle. Moreover, they say, management may be divided.

Hong Kong sources told Caixin that Chen is getting help from a U.S. investment bank for an upcoming road show aimed at institutional investors. He plans to describe the company's latest financial results, which in turn will give Gome's board of directors a good opportunity to communicate with its major shareholders.

A source familiar with these kinds of disputes suggested a deal could be worked out that does not dilute Huang's stake but rather leads to an appointment of a Chen replacement who is someone "the Huang clan trusts. Not someone as conspicuous as Huang's sister as chairman but, instead, with Chen assuming the CEO position."

But that might not be enough to stabilize the retail chain, which before Huang's conviction and the battle for control was a Chinese market leader. The source suggested possible government involvement in hammering out a solution.

"Over time, the source said, "introducing a strategic investor with a government background could help support long-term stability at the company."