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Archive for the ‘China Finance’ Category

Part of the reason I haven’t been posting as much on my blog lately is that I’m currently writing about China equities for Saxo Bank on their platform Tradingfloor.com

So for a regular healthy dose of China equities analysis you can go to my trading floor blog.

I already have three posts up, discussing China’s rebalancing, Auditor track records, and trading the short seller bounce.

As a result I will be talking more about VC and PE matters on this blog, as I have a feeling running two blogs about equity investing will quickly get tedious enough to drive me insane. I do expect some of the important topics to be relevant for both blogs, but as the viewpoint on trading floor is very much that of an equity investor I’ll attempt to stick to a more early stage view here.

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As regular readers of this blog will be aware, I am currently doing some research on Chinese companies going private from the US exchanges with my colleague Jens Ørding Hansen. During this process we have collected some data that, while not fitting into the overall narrative of our paper, is nonetheless very interesting.

One of these interesting sets of data regards what happens in the trading of these companies leading up to the going private proposal. We looked at the data in a few different ways, and found what appears to be indications of “information leakage”.

Jens then took the time to actually compile this data into some very useful and informative graphs that we believe will interest some readers.

Firstly, we looked at the difference between prices leading up to the proposal and the price development on the proposal date.

As we can see here there are some interesting developments in the price of some of these equities before the actual proposal to go private, to the extent that we sometimes even see large increases pre-proposal followed by negative reactions to the actual proposal.

Looking more closely at the developments leading up to the proposal we decided to split the data into the 7 days leading up to the proposal and the day prior to the proposal. As we have already seen some evidence of abnormal price increases, and there is already some documented evidence of options trading spikes leading up to going private proposals, we decided to look at trading volumes.

Starting with the average trading volume for the 7 days leading up to the proposal, we see some abnormal trading patterns emerging.

These patterns get more extreme if we look at what happens on the day prior to the going private proposal, this is also where we see some of the most interesting gains in stock price.

Some of the price increases and increases in trading volume we see in these companies would suggest that there may indeed have been information about the impending proposal leaking through to investors prior to the announcement. However, it must be said that caution should be used when interpreting these numbers as we did not have enough data available on the companies to compare all the relevant data points. However, there is still enough data here to show that something quite interesting has been happening leading up to some of these going private deals.

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While there are some fairly varying opinions regarding exactly what happened when walmart got conditioned approval for their acquisition of Niu Hai Holdings, one thing at least seems clear: MOFCOM is not overly fond of VIEs.

This certainly won’t be welcomed by foreign investors using VIEs, but its hardly news either. MOFCOM have been the most vocal department when it comes to issues relating to VIEs, for instance in their recent M&A regulations, so a continues negative stance is hardly shocking. What is interesting is how they express their negative views.

They haven’t banned the VIE structure as such, if anything they are acknowledging its existence, but they are limiting the scope under which they will allow it to operate. So far I don’t think this will cause any major issues for Walmart, so from their point of view this is probably a pretty good result.

Other VIEs might want to take notice of the restrictions, however. just in case this turns out to be the start of a trend. While MOFCOM can’t really declare VIEs illegal, they may find a simpler solution in simply restricting their business scope until they are basically useless.

Seasoned watchers of the VIE space will know to take any such hints of future regulatory enforcement with caution though, as we have seen similar things before, with Buddha Steele for instance. What we can say is that MOFCOM certainly doesn’t seem to like VIEs, and if you cannot ban them limiting them is probably your next best option.

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There is currently some debate building about Chinese companies going private from the US exchanges. We saw a wave of these deals a while back but it has been relatively quiet as of late. This could all change, however, with the increased involvement of the CDB to help secure financing for the deals.

While the motivation for taking a company private from the US exchanges is relatively easy to understand, mostly low valuations coupled with the cost of complying with listing requirements. It is more difficult to see where the alternative exit is for the people who go into these deals, something discussed in this article.

Couple that with reports of sharply diminishing returns from domestic IPOs and it seems that a lot of PE funds that were involved are likely to sit on some bad assets. It is certainly fair to say that anyone hoping for a quick delist-relist deal will have been very disappointed with the current situation.

But this does not mean that these deals do not make sense.

One of the major factors why is valuation. The sheer amount of PE money in China at present is pushing up the price of acquisitions, but distrust on the US markets has pushed even the prices of solid profitable companies down. Way down.

Looking at the data we find that the average market-to-book of Chinese companies that have received going private proposals 3 days prior to the proposal is just under 1. This means that the stocks were trading below book value on average, and there are plenty of companies that were well under 1.

With these types of valuations it is possible to offer a good premium and still get a company with a good track record of profitability at fire-sale valuations. The average implied market-to-book of the offers was 1.31. Again these are averages so we even see companies where the implied market-to-book of the offers are under 1.

Now say what you will about the issues of exiting these investments in the future, but with lots of money hanging about in search of a deal in China you would be hard pressed to find more alluring valuations.

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In a move that is likely to have many investors in China concept stock scratching their heads the Chinese government has further restricted access to SAIC filings, often used as the start of any due diligence on a Chinese investment. The new rules make it virtually impossible to get detailed financials, as filed to the Chinese government, without the expressed consent of the company involved.

While there are limits to what you can tell by comparing SAIC filings to those made by the company overseas it is nonetheless the preferred starting point of most DD professionals and can act as a good road map for where to look in more detail. So restricting, or in effect banning, access to these files will cause some very real problems for investors looking to confirm the validity of a company’s financial statements.

Some are speculating that the reason behind the new restrictions is the use of SAIC filings in short reports written by muddy waters et al. While this may well be true, the effects of the policy will likely be much more widespread as the filings are also used to confirm financial information by investors looking to take long positions in Chinese companies. Perhaps most interestingly, checking SAIC filings was always a relatively cheap way to get some level of confirmation about a company’s financials. The alternatives that we are left with are likely considerably more time consuming and expensive, so these restrictions are potentially putting a higher value on reliable China DD.

The timing of the change in policy could also have been better, coming on the back of delistings,  companies unable to file financials on time, and changes in ownership of the big 4 in China this adds more uncertainty that foreign listed Chinese companies certainly don’t need right now. Something that may prompt companies to act on their own to provide some level of transparency for their investors.

In such an uncertain climate, one way to assuage investor concerns might be to grant any holder of a company’s ADS the right to review its SAIC filings. Whether this will happen or not investors are unlikely to act in a positive manner to restrictions in their ability to double check companies in a sector historically prone to misstatements and frauds.

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Dan Loeb and the team looking to shake up the leadership of Yahoo! are naturally very interested in how they can use their stake in Alibaba to create more value for their shareholders. But if they are looking to take the road of an activist investor in the China internet sector it is important that they learn from the ChinaCast and GigaMedia examples and understand how a VIE will influence their position.

ChinaCast’s  problems started when a group of investors wanted to shake up management of the company by ousting Ron Chan and some other senior people from the company. However, it seems like they have seriously misunderstood the strength of their position. Perhaps they should have learned from what happened at GigaMedia before storming in to change management in a company using a VIE.

This case is different from GigaMedia in that the person at the centre of the dispute doesn’t hold any equity in the VIE, however, other parties involved hold at least 40% of the VIE equity. And considering the VIE holds the vital licenses to operate the business this dispute is certainly no trifling matter.

When foreign players in the internet market in China come in and try to force aggressive changes like they would in any other market they are misjudging their negotiating position toward the VIE equity owners. If the company itself had equity ownership over all the entities forcing this type of change would be routine, but in a VIE situation the position of the company is potentially secondary to the VIE equity owners who work for them.

Only having contractual control of an entity comes with certain problems when disputes like this emerge. Even if we assume that the contracts are all valid and enforceable (we have no info on whether the equity pledge is registered or not), the company still has to go through the courts to regain control of their entity, something that can be expensive and time consuming. For instance, GigaMedia has set up an entirely new China operation while the legal proceedings appear to be on going.

With so much uncertainty and the potential of a lengthy court battle investors and owners need to plan ahead before they act against management holding VIE equity. In fact, getting your VIE related affairs in order beforehand is likely not just prudent, but necessary as witnessed by the outcome for GigaMedia.

These two examples clearly show the perilous situation companies can get into when they misjudge their position towards the VIE owners. Yahoo! have already been burned once in a VIE related affair, but if they want to be more active in their China assets they need a plan for how to deal with the VIE equity holders or they risk getting burned again.

Available in China without a VPN here.

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There are reports coming out now that the VIPshop.com IPO is going to be pulled, due to lack of interest from investors. This move will hardly be surprising for people who have followed the reception of the F-1 filing and the roadshow.

A more important question is what this means for Chinese IPOs as a whole. Has the window just been slammed shut on Chinese IPOs, or is this more of an isolated incident? To me at least it looks a lot more like the latter.

The company did not look like a tempting proposition in almost any respect, and there were a few red flags to go along with it, so I don’t think we can use this as a good temperature gauge for better-looking Chinese IPOs. I suspect AdChina, and possibly Cloudary, might be the IPOs used to judge the market appetite for more Chinese listings in the near future.

A couple of quick comments on why I don’t think VIPshop.com was an attractive offering to begin with might be in order, in case you haven’t read the filings.

The company was losing money at an increasing pace, and it was hard to see how the company was going to turn it around. The business model was also very “heavy”, by which I mean the company had a very long supply chain (warehousing, sales, after sales services, distribution etc.) and was probably taking on too much.

To top this off they had a VIE contract that must be an absolute nightmare for anyone working with transfer pricing issues, leaving the company open to very large tax liabilities indeed.

All in all, I’d wait for the AdChina IPO reception before I start declaring the IPO window for Chinese companies is definitely closed.

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