The Rise and Fall of VAM Agreements in China's Capital Market
This term seems to be quite common in the capital market, appearing with high frequency. I even looked it up online, and its English translation is "Valuation Adjustment Mechanism" or "VAM." However, I've never heard of this term being used in the English-speaking world. It seems to have been taken to a whole new level in the domestic capital market of China. Because of VAM agreements, some have laughed all the way to the bank, while others have fallen into the abyss, losing everything, ending up bankrupt, or even imprisoned.
It feels like many big names in China, even celebrities in the entertainment industry, have to go through several rounds of VAM agreements to level up and succeed. So today, let's talk about what VAM agreements are, their underlying logic and essence, and how this seemingly dramatic agreement has spread so rapidly throughout the entire domestic capital market of China.
What is a VAM Agreement?
As its name suggests, a VAM agreement is an agreement based on a bet. It's a wager between the company seeking financing and the investors. Usually, when companies seek financing, they set a target for themselves. If the company achieves the target as required, it wins the bet. If it fails to meet the target, the investor wins.
The losing party then has to compensate the winning party with something, such as money or equity. It's that simple. That's what a VAM agreement is.
Here's a little humor for you: Let's have a good chat about VAM agreements!
The Case of Mengniu: A VAM Success Story
To my knowledge, the first publicly known case of a VAM agreement involved Mengniu, a well-known dairy company. In the early 2000s, Yili was the absolute leader in the milk market, with a market share exceeding 30%. After all, they had been listed on the A-share market since 1996.
However, Mengniu emerged as a strong competitor, led by its founder Niu Gensheng. It was a meteoric rise.
By the way, Niu Gensheng initially worked at Yili. He was incredibly capable and rose through the ranks to become the vice president. The team he led accounted for 80% of Yili's performance. Later, there were rumors of internal political struggles, and for various reasons, Niu Gensheng left to start his own business, founding Mengniu.
After his departure, nine senior executives from Yili gave up their high salaries to follow Niu Gensheng in his entrepreneurial venture. One after another, over a hundred subordinates also spread the word and joined him.
In their first year, their revenue was only a little over 37 million yuan. However, in just four short years, by the end of 2003, that number had soared to 4 billion, a hundredfold increase! He seemed to know what he was doing.
So later, some even called Niu Gensheng the "Father of the Dairy Industry."
We're getting a bit sidetracked here. Anyway, Mengniu, under Niu Gensheng's leadership, was on a roll. The dairy industry operates on a scale economy. Initially, you need to invest in raising the cows and establishing the supply chain, which requires high upfront costs. However, the marginal cost decreases significantly afterward. You just need the cows to produce more milk, and you can sell it.
In such an industry, as long as there's market potential, the more you expand, the more you earn. Therefore, for Niu Gensheng, as long as the market capacity was large enough, he needed to expand to earn more money. And what does expansion require? That's right: money.
Here's the problem: for Mengniu, a relatively unknown private enterprise at that time, it was extremely difficult to obtain large loans from banks. Niu Gensheng was known for his expertise in product development and marketing, but when it came to the capital market, he was clueless. He was incredibly anxious.
At this time, Mengniu, in dire need of funds, caught the attention of Morgan Stanley. They had been eyeing Mengniu for a long time. It was a time when China had just joined the WTO and was developing rapidly. People's living standards were also improving rapidly. Therefore, the dairy industry, although not yet widespread, had huge market potential.
Naturally, Morgan Stanley also wanted a piece of this pie. The problem was that the industry leader at the time, Yili, already had state-owned backing and had been listed for three years. For Morgan Stanley, breaking into that market seemed impossible.
However, Mengniu was a different story. It was a typical startup with a promising market and rapid development. Niu was also very capable, bringing with him a group of experienced executives from Yili. Most importantly, they were truly in need of funds.
Therefore, Morgan Stanley, along with CDH Investments and Investec, approached Niu Gensheng. On one side was a high-quality company in need of funds, and on the other side were investors with funds seeking a high-quality company. Wasn't it love at first sight?
In 2002, Morgan Stanley, without hesitation, invested US$26 million in Mengniu, equivalent to RMB 210 million at the time. The following year, Mengniu grew rapidly. Following the logic we just discussed, they needed more money.
So Niu Gensheng approached Morgan Stanley again, asking for further investment. Morgan Stanley had the funds, but after careful consideration, they felt that additional investment carried significant risks. After all, China's capital market had only developed in the past few years. Both legal protection and market rules were not yet well-established.
Therefore, to protect their interests as much as possible, Morgan Stanley told Niu Gensheng: "Brother, we are very optimistic about Mengniu and you, Niu Gensheng. We are willing to invest another US$35.23 million." (I'm not sure how they came up with that figure, but it's roughly equivalent to RMB 290 million).
"However," they added, "BUT, we have a condition. Let's set a target. If Mengniu's compound annual revenue growth rate exceeds 50% in the next three years, we, the investors, will give you an additional 78.3 million shares, which is about 6% of Mengniu's shares. If you fail to achieve this performance target, Mengniu will have to give us that same amount of shares."
Morgan Stanley's plan was beautiful. If Mengniu's performance skyrocketed and their annual growth exceeded 50%, they could easily go public. Even if they had to give some incentives to the management team, it would be reasonable. If they didn't achieve the target, it wouldn't be a big deal. They could still get some shares as compensation. Either way, they wouldn't lose.
Niu Gensheng, on the other hand, faced the risk of losing some equity if he failed to meet the target, but it wouldn't bankrupt him. He believed his chances of winning were high. After all, even mature companies like Yili had compound growth rates exceeding 50% in the previous few years, let alone a rapidly growing company like Mengniu. Moreover, the objective reality at that time was that Mengniu couldn't raise that much money through other channels. Think about it: over these two rounds, the PE had invested a total of RMB 500 million, giving them three years to develop, and even helping them go public. Considering all this, Niu felt it was worth the gamble.
Both parties reached an agreement, and the VAM agreement was in place.
The Outcome of the Mengniu VAM Agreement
Let's fast forward a bit. With the investment secured, Mengniu developed rapidly. In 2004, they successfully listed on the Hong Kong Stock Exchange. In 2005, they leveraged the phenomenon of Super Girl, a popular singing competition, for marketing. Their annual revenue almost doubled every year. By 2006, they even surpassed the industry leader, Yili, easily achieving the VAM target.
Mengniu won the VAM agreement. The management team received over 60 million shares and immediately cashed out HK$1 billion.
Although Morgan Stanley lost the bet, Mengniu went public. They cashed out HK$2.6 billion in the secondary market. Their return on investment in Mengniu exceeded 550%.
Understanding the Implications of VAM Agreements
After seeing the example of Mengniu, you probably have some idea of what a VAM agreement is. It's essentially an additional clause added by investors during financing to hedge against future uncertainties. This target could be financial, like in the case of Mengniu, where the growth rate in the following years must reach a certain level. Or it could be a direct requirement, such as mandating the company to go public within a certain timeframe, like in the case of South Beauty, which we'll discuss later.
The content of the rewards and penalties is usually straightforward: either equity is given, or it's cold, hard cash. If the target is not met, the money is returned. Take, for example, the case of South Beauty, which we'll discuss shortly.
You might be thinking: although it's called a VAM agreement and sounds like a fair bet between two parties, it always feels like the investors have the upper hand.
You're absolutely right.
Financing and investment boil down to investors believing in the company's potential, so they invest and join the ride. They should share both the profits and the risks. However, with the addition of this extra VAM clause, if the company makes money, the investors may earn a bit less, but the company can earn more. But if the company loses money, the investors are virtually unaffected, while the company has to bear the loss, and sometimes even the founders are personally liable, ending up on a debtor's list.
This creates a situation where a seemingly fair bet significantly reduces the investor's risk while increasing the risk for the company seeking financing. Remember, finance is a game of risk and return. High risk corresponds to high return. By signing a VAM agreement, investors essentially reduce their own risk, indirectly improving their Sharpe ratio. In other words, you could say their return on investment is increased.
And this is assuming the VAM clause itself is relatively fair. The reality is often different. Cases like Mengniu are relatively rare because, at that time, capital had just entered China and wasn't willing to play too aggressively. However, as capital gradually gained more power, it became more demanding.
The Case of South Beauty: A Cautionary VAM Tale
If I don't talk about South Beauty now, you'll probably beat me up.
South Beauty, a high-end chain restaurant brand, was extremely popular and expensive between 2008 and 2010. I remember when I was a sophomore, I went to Shanghai to see the World Expo. I was starving and walked into a South Beauty restaurant. After looking at the menu, the prices really scared me a little. I ended up ordering a small bowl of noodles and left hungry.
Zhang Lan, the founder and owner of South Beauty, claimed she wanted to create the "Louis Vuitton of Chinese cuisine." After its establishment in 2000, the company went from strength to strength. By 2008, it became the sole Chinese food provider for the Beijing Olympics, with 70 stores nationwide and a daily net profit of RMB 2 million. The company was valued at RMB 2 billion.
Zhang Lan boldly proclaimed, "Wherever there is Louis Vuitton, there will be South Beauty! In the next decade, we will become a Fortune 500 company, and in the decade after that, we will be in the top three!"
With the business running so smoothly, Zhang Lan naturally thought about going public. Before the IPO, she wanted to raise more funds. That's when CDH Investments appeared again. You saw them earlier with Mengniu, and now they're back with Zhang Lan, still wanting to use a VAM agreement.
What was the bet this time? Simple: I bet that South Beauty will go public within four years. If successful, well, it's a successful IPO, and there are no other rewards. But if it fails, I'm sorry, Ms. Zhang, but you have to return all the investment money, plus a reasonable return rate, said to be 20% annualized. CDH also made sure to cover the worst-case scenario by adding a clause stating that if Zhang Lan couldn't come up with the money, CDH could sell her shares to recover their investment. They wanted to guarantee the safety of their principal.
You might be wondering: why did Zhang Lan agree to such harsh terms? Her catering business wasn't high-risk, and the cash flow was stable. Why not take it slow and steady? Why bother?
At that time, she was a bit blinded by her success and overly confident. She saw other catering companies like Quanjude and Xiang E Qing successfully listing. Plus, CDH had both the funds and the experience. To her, going public was a piece of cake for South Beauty. In the worst-case scenario, the bet was just about money. Even if she didn't meet the target, she could just buy back the shares. The company would still be hers.
Therefore, Zhang Lan happily agreed.
Zhang Lan was in the limelight after securing the investment. She gave speeches everywhere. Her son, Wang Xiaofei, the CEO of South Beauty at that time, also married the celebrity Barbie Hsu in a high-profile wedding. South Beauty submitted its IPO application to the A-share market in 2011.
However, the good times didn't last. In January 2012, the China Securities Regulatory Commission announced a list of terminated IPOs, which included many catering companies, with South Beauty prominently featured. The reason given at the time was that the catering industry involves a lot of cash transactions on both the purchasing and sales sides, making it difficult to guarantee the authenticity of financial reports.
Zhang Lan was stunned. At this point, there were only eight months left until the deadline of the VAM agreement. She hurriedly tried to list in Hong Kong. Of course, there were rumors that South Beauty had financial problems. In the end, the Hong Kong listing also failed.
Two failed IPO attempts triggered the repurchase clause in the VAM agreement. Unfortunately, South Beauty had been hit by the financial crisis in the past two years and couldn't come up with the RMB 400 million to buy back CDH's shares. This triggered the second layer of the VAM agreement mentioned earlier: the right of first refusal and liquidation preference.
Therefore, CDH found a European private equity firm, CVC, and sold 82.7% of the shares held by CDH and Zhang Lan for US$300 million. CDH walked away with the money.
Although CVC tried various methods to salvage South Beauty, they ultimately couldn't save it. The founder, Zhang Lan, left the company.
The case of South Beauty is more common in the capital market. Instead of betting on performance and development, investors bet on the most tangible outcome: whether the company can go public. If it goes public, they exit with the money from the secondary market. If it doesn't, they get their money back with interest.
Ultimately, VAM agreements are a way to redistribute the interests between investors and companies seeking financing. Naturally, a balance is struck in the market. Therefore, the higher the risk, the more likely VAM agreements are to appear.
VAM Agreements in the Entertainment Industry
You might be thinking of another high-risk industry: the film and television industry.
The uncertainty in the film and television industry is huge. The success of one person can revive an entire company of hundreds, but the downfall of one celebrity can completely destroy it. Moreover, there's a significant information asymmetry in the entertainment industry.
You can check the accounts and financial reports of a company. But for investors, the gossip and rumors surrounding celebrities are impossible to monitor. So they turn to VAM agreements, letting the celebrities regulate themselves.
For example, many film projects nowadays involve VAM agreements to guarantee a minimum box office revenue. I've heard that movies like "Wolf Warrior 2," "Ip Man 3," and "The Mermaid" all had such mechanisms in place.
Of course, these VAM agreements sometimes force filmmakers to hype up and promote even terrible movies.
Some celebrities also use their own output and earnings for VAM agreements when seeking funding, promising to earn a certain amount or achieve certain performance targets within a specific timeframe.
For an industry like entertainment, which can be quite complex, VAM agreements can indeed help investors mitigate the negative effects brought about by information asymmetry.
Conclusion: VAM Agreements: A Double-Edged Sword
In conclusion, VAM agreements are a safety net for investors to protect their downside risk. However, you might wonder if investors in every country want to protect their downside risk. The difference is that in Europe and the United States, the mechanisms are more mature, so investors have more tools at their disposal.
These tools include preferred shares, convertible bonds, structured bonds, and more, all of which are weapons for investors to protect their downside risk.
However, VAM agreements have one distinct characteristic: while traditional agreements between companies and investors are typically at the corporate level, VAM agreements often extend to the personal level, holding founders personally liable, potentially leading to personal bankruptcy.
For example, Luo Yonghao ended up on a debtor's list because of a VAM agreement.
Ultimately, if something exists in the market, it serves a purpose. VAM agreements were a product of the market environment and the circumstances of both investors and companies seeking financing at that time.
As the market environment and legal regulations mature, VAM agreements may evolve in various ways. However, fundamentally, the desire of capital to reduce risk will always exist.
So remember: small bets can be entertaining, but big bets can be harmful.
That's why later, some even called Niu…