Carlyle Group in China

I. Brief description of the deal

Pre-acquisition: Xugong's parent, Xuzhou Construction Machinery Group, owned 51% of the company.

Post-acquisition: By getting loans from foreign banks and reselling shares of Xugong to other investors, Carlyle will finance $375mil and attain 85% of the company. Xuzhou Construction Machinery Group might get loans from Citi to buy stakes from other state-owned entities and resell the stakes to Carlye, and Xuzhou Construction Machinery Group will own 15% of the company after the acquisition.

II. What risks we’ll face from making this investment, and what signposts, shaping, and hedging factors we should consider

a. Risk 1: The government’s disagreement on the price and shareholding structure of the deal

• Assumption: the central government will approve the deal in due course. (load-bearing and vulnerable assumption)

• Signposts: significant delay in approval process, debates in the country on the validity of the buy-out (is the deal a cheap selling of state-owned assets? Will that harm the economy security of China?)

• Shaping factors: lobbying Chinese government officials by all means, e.g. asking US government officials to help lobbying; maintaining good relationship and understanding with the company’s parent company, who would also solicit support from the government.

• Hedging factors: reevaluating the deal and making necessary, reasonable compromise on the acquisition price and post-acquisition shareholding structure

b. Risk 2: Competitors (such as caterpillar and JP Morgan) win the deal

• Assumption: Carlyle is the candidate most favored by Xugong and will most likely win the acquisition (load-bearing and vulnerable assumption)

• Signposts: any progress in other competitors’ negotiation with Xugong, signals to reflect the progress include disclosed news, memos and even rumors

• Shaping factors: closely monitoring the negotiation between Carlyle and Xugong; assist Carlyle to maintain a good relationship with Xugong

• Hedging factors: switching to other funds/ competitors if they turn out to have more probability to win the deal, given the price is reasonable and the expected return is attractive.

c. Risk 3: After the acquisition Xugong fails to deliver satisfying return to the shareholders

• Assumption: Xugong will continue to be the leading player in its industry (load-bearing and and vulnerable assumption)

• Signposts: changes in profitability figures and market share

• Shaping factors: closely monitoring the competitive status of the industry, business growth of Xugong and the management team’s capability to formulate appropriate strategies to respond to the external environment; if our investment is significant enough to obtain some seat in the board, we can better supervise the management

• Hedging factors: selling the shares to others if Xugong’s business shows significant downturn

III. Two different alternative futures for China that bear on this investment and the two corresponding scenarios our bank could face.

a. Alternative 1

• Future for China: growing sense of nationalism, reluctance of the government to allow buy-out of big state-owned entities

In this case, the sense of nationalism will grow in China. People tend to hold negative opinion about the intention of foreign firms to buy Chinese entities. Chinese always have the “self-reliance” philosophy that Chinese people is a great people and is therefore, able to accomplish anything completely on themselves. During the recent reforms of privatization of state-owned assets, more and more debates arise regarding the validity of some deals, with a wide-spread suspicion that some of the deals done with foreign firms are so cheap that damages the interest of the country as a whole.

Meanwhile, just as the US government is worried about its economic security if Chinese entities control those important industries in the US, such as oil, transportation etc., the Chinese government might have the same worry, which will get worse with the escalating trade conflicts between the two countries. Therefore, the Chinese government might be reluctant to allow buy-out of big state-owned entities by