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Caterpillar Caper Bugs China's Private Equity Market

Tickers in this article: CAT CG KKR
TAIPEI ( TheStreet) -- Caterpillar (CAT) is known as a careful company. The world's top producer of construction equipment is no stranger to China with 23 manufacturing bases and 15,000 workers. So when the firm announced accounting fraud at a recently merged Chinese firm, it made investors look again at the country.

We're supposed to think China gushes with income for private equity investors who buy profitable local firms, in boom industries such as construction and at the right prices.

Caterpillar must have thought it had scaled that great wall of gold when it bought Hong Kong-listed ERA Mining Machinery Ltd and its subsidiary Siwei in mid-2012. The U.S.-based company with 2011 revenues of $60.1 billion had paid the equivalent of $653.4 million for Siwei, China's fourth-largest maker of hydraulic roof supports.

We're also supposed to remember that this is China. Rule of law is weak, so the weak, or even the strong, easily get scammed.

And being screwed is not the only problem with Sino-foreign private equity deals. There's at least another big one -- as well as hope for the wiliest dealmakers.

As the Caterpillar caper was unfolding, I talked to C.Y. Huang, chairman of the Taiwan Mergers & Acquisitions and Private Equity Council. His Taipei-based investment bank has brokered more than half a billion U.S. dollars in the past two years, leading foreign funds to mainland Chinese companies in food service, cosmetics, packaging and tea retailing.

Huang says the trick is doing intensive background checks to avoid scams but stop just short of so much diligence that the Chinese party gets angry and walks off.

"Upon your nice face, who knows whether you are a crook or a scoundrel?" Huang says.

Caterpillar found the problem during an inventory check of the Chinese firm and announced plans to take a goodwill impairment charge of $580 million. Calling the case "deliberate misconduct" that began several years prior to the acquisition, it also fired some of the scoundrels and hired better people.

"The actions carried out by these individuals are offensive and completely unacceptable," Caterpillar CEO Doug Oberhelman said in a statement on Jan. 18. "This conduct does not represent, in any way, shape or form, the way Caterpillar does business or how we expect our employees to work."

Apparently investors know that. Share prices for the world's largest maker of earthmoving, construction and mining equipment fell 2.19% from Jan. 22 to Jan. 25, but they have risen past the Jan. 22 level since then.

In what has shaped up as an iconically famous case, Toronto-listed Sino Forest Corp. was accused by a short seller in 2011 of overstating revenue and giving false numbers about its timber acreage rights in China. The Canadian stock exchange forced the company to delist last year.