FORTUNE — Seven years ago, a listed Chinese energy company called Titan Petrochemical leased out Hong Kong office space in the landmark Two International Finance Centre. Across the hall was the local office of global private equity firm Warburg Pincus, which had become interested in Titan’s recent expansion into the oil storage market.
The two groups began getting to know each other better, eventually culminating in an oil storage joint venture of which Titan would hold 50.1% and Warburg Pincus would hold 49.9%. Warburg Pincus invested an initial $100 million for its stake in the JV — which would operate as a subsidiary of Titan — and also bought around $75 million worth of shares in the parent for a 9.9% ownership position.
Over the next few years, the joint venture grew into China’s largest independent oil storage company. But then problems began to beset the parent company, particularly in the area of crude oil shipping. By late last year, the company faced the prospect of defaulting on junk bonds that had originally been secured in 2004. Titan restructured most of the notes, but still held many with a March 2012 maturity that it couldn’t meet (particularly after a planned shipyard subsidiary sale fell apart).
Once Titan defaulted on its bonds, an opportunity arose for Warburg Pincus. It had structured the original JV with change of control warrants if the parent company became insolvent (which occurred on March 19), and a source familiar with the situation says that Warburg Pincus began digging much deeper into the JV as the bonds neared maturity. It always had been involved at the board level, but now wanted a much fuller picture of what was happening within the lower-level operating and finance units.
What it claims to have found was disturbing, according to a lawsuit Warburg Pincus brought this week against Titan and certain Titan executives: Approximately $232 million worth of loan guarantees to Titan’s flailing shipyard unit (the one it couldn’t sell). It believes the guarantees were originally made by Titan’s then-chairman Tsoi Tin Chun, and then intentionally shielded from being disclosed to Warburg Pincus (including in its board role). The suit claims misrepresentations and breaches of contract.
Why this would matter for Warburg Pincus goes well beyond basic corporate governance and hurt feelings.
The private equity firm did ultimately take majority control of the JV, but earlier this month decided that the only way forward was through a court-approved restructuring. This may take the form of a pure liquidation — Warburg Pincus also happens to be listed as a creditor — but more likely would involve new equity and debt investors. The problem is that the $230 million in disputed loan guarantees makes new lenders much more difficult to find, or at least much more difficult to find at generous terms. And the ongoing dispute itself may make such loans impossible to find at any price.
To be clear, these are contingent liabilities. The joint venture has not yet been required to come up with any of the $230 million. All that is really affected is credit-worthiness and, thus, the ability to restructure.
Even if the court agrees with Warburg Pincus, that does not necessarily mean that the firm will profit from its original JV investment. In fact, it would almost certainly lose money if the restructuring occurred within the next several months and new investors acquired all of Warburg Pincus’ position. If a restructuring occurs and Warburg Pincus retains at least some stake, then there is at least the possibility of profit.
As for its investment in the parent company, Warburg Pincus already has sold around half of its stake and a Chinese strategic has offered to buy the remainder (via a broader takeover attempt of the entire company). Fortune has not been able to learn if the stock sales and buyout offer would result in a net gain or loss for Warburg Pincus on the overall Titan investment.
Titan has not yet responded to the charges in court, and told Reuters that it would have no public comment until it is served with, and has a chance to review, the suit.
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