Yoshiaki Fujimori (R), president and CEO of Japan's largest manufacturer of housing facilities Lixil, shakes hands with David Haines (L), CEO of the world's leading provider of premium bathroom appliances Grohe, during a press conference in Tokyo on January 29, 2014
Yoshiaki Fujimori (right) shakes hands with David Haines, Grohe chairman, before Lixil acquired all of the German group © AFP

The letter from the Chinese bank arrived on April 15, 2015, only two weeks after Lixil, the Japanese building materials conglomerate, acquired the whole of Grohe, the German bathroom fittings group.

Joyou, Grohe’s Chinese subsidiary, had not repaid a small loan, the letter explained. Lixil management’s initial reaction was surprise. Had they not just paid Joyou’s Chinese founders €205m for their remaining stake in Grohe?

The outstanding loan turned out to be the tip of an iceberg, forcing Lixil shortly afterwards to warn investors it faced Y66bn ($560m) in losses after Joyou AG filed for insolvency.

It emerged that Joyou had collateralised its Chinese factories several times over to raise funds from multiple lenders. Because Joyou then lent some of that money into China’s sprawling shadow banking sector, the collapse of a lending pyramid in southeastern China was able to blast a hole in Lixil. As the Japanese group integrated Grohe, Chinese manufacturers were battered by slowing growth. Banks called in loans from businessmen who had re-lent into the shadow market. Defaults soared.

“Multinationals underestimate the risks associated with shadow banking,” says Paul Gillis, of Peking University’s Guanghua School of Management.

More broadly, the saga illustrated the perils of a big foreign acquisition involving an emerging market like China. In December Yoshiaki Fujimori, Lixil’s chief executive, stepped down. He insisted his resignation had nothing to do with Joyou but the scandal blighted his strategy of rapid international expansion.

As Lixil works to recover some of the money, Joyou’s founders are battling claims from banks in China. The fact that some of the funds flowed into the shadow banking market further complicates shareholders’ and lenders’ attempts to recover some of their losses. Foreign creditors of Chinese groups listed overseas have rarely been successful in liquidating or gaining control of disputed assets in China.

Key dates

1979 Cai Jianshe founds a business that eventually becomes Joyou
2004 TPG and Credit Suisse buy Grohe for £1.5bn
2010 Joyou lists in Frankfurt. Grohe owns 7.1 per cent
2011 Lixil is formed by merging five bathroom and building materials companies
2013 Cai family trades stakes in Joyou AG and Joyou Grohe Holding for 12.5 per cent in Grohe. Grohe owns 72.3 per cent of Joyou AG
2014 Lixil and Development Bank of Japan buy 87.5 per cent of Grohe. Joyou’s Hong Kong unit borrows $300m from Mizuho, Bank of Tokyo-Mitsubishi and Sumitomo Mitsui Banking Corp. It pays off outstanding loans to HSBC, Nomura and Standard Bank
April 2015 Cai family’s German holding company sells remaining 12.5 per cent of Grohe to Lixil
May 2015 Joyou AG files for insolvency
June 2015 Lixil warns investors of Y66bn ($560m) in losses over three years from Joyou AG bankruptcy

The saga has its roots in 1979 when Cai Jianshe founded a tap-making workshop in Fujian province, just as Beijing launched market-style economic reforms. Thirty years later Mr Cai and his son, Cai Jilin, had become bigwigs in their home town of Nan’an, an industrial hub on China’s southeastern coast.

Their company was now one of China’s biggest in the bathroom fixtures sector, listing on the Frankfurt stock exchange in 2010 when it raised €105m in an initial public offering.

Two years before the German listing, and a year before forming a strategic partnership with Grohe, Joyou reported a 200 per cent increase in sales of its core business of bathroom fittings.

Similar jumps at other overseas-listed Chinese firms have alerted short sellers to search for possible falsified accounting. Yet Lixil did not suspect problems until the Chinese bank’s letter arrived. It then discovered “fraudulent accounting” dating from 2008, including off-the-books loans “at extremely high interest rates”, according to Lixil’s summary of its subsequent investigation.Both Cais declined interview requests, while Lixil answered questions by email.

Lixil concluded that Grohe and Lixil management “had no actual knowledge of” the dubious accounting, even though “Grohe management held a number of general concerns about Joyou”.

By the time Joyou listed in Frankfurt in 2010, Beijing’s restrictions on lending to private property developers had created a two-tiered interest rate market. Anyone who could obtain bank loans — for instance, by pledging a factory as collateral — could profit enormously by lending into the shadow market at much higher interest rates.

In Nan’an, many entrepreneurs joined the private lending craze.

In 2011, shortly after the Cais sold part of their stake in Joyou AG to Grohe, the elder Mr Cai registered a microcredit firm. That year, microcredit loans fetched between 24 and 45 per cent interest.

The Xinyu Microcredit firm “strengthened Joyou’s capital flow”, his son told a provincial official in July 2014.

“Bosses with ideas and resources of course want to get involved in the finance industry. Besides, it’s not as hard as manufacturing,” Sina, the news portal, reported from Nan’an in the spring of 2014, quoting an unnamed executive.

In October 2014, the lending pyramid in Nan’an finally collapsed. with the arrest of a financier called Wu Shanhe. His downfall wiped out hundreds of millions of renminbi in shadow loans.

Grohe’s German brand — rather than its China presence — was the prize when Lixil negotiated to buy Grohe, according to two people involved in the deal who declined to be named because they were not authorised to talk about it.

Despite the problems with Joyou, the Grohe acquisition “has brought tremendous value, both financially and strategically, to the Lixil Group”, says Jin Montesano, Lixil’s chief public affairs officer.

In July 2015, Lixil ceded control of Joyou AG to a court-appointed bankruptcy administrator.

By December, German regulators were investigating possible insider trading and market manipulation in Joyou AG’s shares. Meanwhile, the Cais are still running the factories they founded in 1979, in spite of the millions that have slipped down the drain since then.

Additional reporting by Luna Lin

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