Feeds:
Posts
Comments

Archive for the ‘China Investment’ Category

As the accounting issues between the US and China escalates investors in China concept stocks aren’t the only ones scratching their heads. Equally troubled are the country’s VC and PE firms who were just starting to see a light at the end of the tunnel with YY’s recent IPO.

People may be underestimating the potential losses for China if the US markets were to be closed off, in particular when it comes to the technology sector. There are currently many young promising Chinese tech companies, but most of them have at some point taken in foreign capital to grow, which means they will have a VIE structure in place.

A VIE structure and foreign shareholders will automatically rule out a domestic listing, so the only possibility is to go abroad for an IPO exit or try to find M&A options in China, something that has been very slow moving so far. A foreign exit has traditionally meant one of two places for up and coming Chinese tech companies: US or HK.

The problem we could face now is that the US exchanges will close completely for Chinese companies, and HK’s new VIE regulations means it should be all but impossible to list the company their either. At that point we’re left with the “secondary exchanges” for Chinese companies, most likely London or Singapore.

However, these exchanges don’t have the same history of taking in Chinese companies, much less the soon-to-be-big tech companies and their disclosure rules for VIEs are relatively lacking. These factors combined mean that the ambiguity and risk both for investors and the company that wants to IPO increases, and if there’s one thing Chinese companies and investors in them don’t need right now it’s more ambiguity and risk.

This development poses very real problems for the country’s VC and PE firms, and in turn for innovation and new company creation in some vital Chinese industries.

A lot of the debate seems centred around the issues this will raise for investors and the US role as central capital market, but China does not walk away scot-free from this either. And decreased private investment in key innovation industries is not what China needs right now.

Read Full Post »

The big talking point last week was undoubtedly the New York Times article that laid out the personal wealth of Wen Jiabao’s family in great detail. It was a piece of reporting very reminiscent of the earlier Bloomberg piece regarding the wealth of Xi Jinping’s immediate family, and the result of both articles has been the same: immediate blocking of the entire site inside China. But there are other potential repercussions because of this as well, and they have the potential to harm investors and Chinese stocks listed overseas.

Both stories used Chinese records to build and confirm the bulk of the data they presented, this is also commonly done when conducting due diligence on Chinese companies. These are the SAIC filings where you can find a lot of data about a company to help guide your due diligence process. It used to be that you could get all manner of economic data from the SAIC files, but access rights were severely restricted earlier this year, which forced due diligence professionals to adapt their processes.

It was widely speculated that the restricting of access to the SAIC files was a response to them often being used as a first stop when the now infamous short sellers were putting together reports on Chinese companies. The theory then went that because these reports were having a negative effect on Chinese stocks overall, as the perceived fraud risk increased, the political class stepped in to try to limit the short reports and decrease the downward pressure on Chinese stocks. It may even have been the case that the reason for the political class to move on the issue was that they were themselves losing too much money because of the stock decline.

The risk we face, now that these reports have been put together, at least to some extent, based on the SAIC filings is that access will be restricted even further. This would cause a multitude of problems for conducting due diligence in China, and it would add uncertainty to the market for China concept stocks as it would become even harder to confirm holdings, or even simple things like ownership.

This is especially problematic for people who trade Chinese stocks on the IFRS exchanges, as disclosures from companies on these exchanges tend to be much less detailed. The classic example for me in this is the fact that you can still report a VIE as a subsidiary under IFRS. The classic check on this would be to pull the SAIC filings to find out who were the actual registered equity owners of the entity in question, if you remove this option then investors truly are flying blind.

What’s more, this will probably also increase the costs of performing due diligence in China, which would harm smaller investors more that institutional players who have enough money involved to warrant the outlay. With the easy option of checking SAIC filings for suspicious discrepancies gone investors will need to find other ways of red flagging potential investments, it will also increase the value of having a good network set up for conducting due diligence.

Further, In my opinion it’s quite the opposite of what the overseas listed Chinese companies, especially the small- and mid-cap companies, need right now. many of them appear to be legitimately undervalued and would benefit greatly from increased transparency to help soothe investors concerns regarding them.

Read Full Post »

This post was written in collaboration with Jens Ørding Hansen from University of Agder with whom I’m writing an academic paper on Chinese companies going private from the US exchanges.

Last week saw the announcement of the largest ever going private (GP) proposal for a Chinese company on the US exchanges. Focus Media had a market cap over 3 billion USD, pushing the record for largest market cap for a Chinese GP from a previous high of 1.8 billion.

This deal can be seen either as a continuation or a new beginning, depending on your perspective. On the one hand the deal fits the trend of Chinese companies going private from the US that many people expect to continue; on the other hand the deal sticks out from the recent trend in some respects.

The sheer size of the deal is the first, and most eye-catching, way that it sticks out. 75% of GP proposals for Chinese firms fall within a range of USD 50-390 million for market cap, with an average of 288 million. So with a deal over 10 times the average historical value we really are talking about an anomaly.

It could be argued that what we’re seeing here is the start of an exodus trend for the larger Chinese companies that are listed in the US. However, the other big GPs we have seen have not resulted in a discernible trend of large companies heading back to China. What we have seen is that one or two larger deals seem to come before more GP proposals among the smaller firms.

Another interesting aspect of this deal is that it does not include China Development Bank (CDB) funding, something that many thought was going to be the driving force behind the next wave of GP transactions. This was especially true after the CDB agreed to provide funding to help close the Fushi Copperweld deal.

This is not entirely out of character for the CDB as a policy bank, however, as they may be allowing market forces to play out before they decide on stepping in to help close deals. Because there was enough financial backing for the Focus Media deal the bank didn’t actually need to step in, at least not yet.

It might be that the bank is more likely to step in and help conclude some of the old GP deals that have been languishing, seemingly unable to close. There are still 6-8 older GP proposals that are seemingly stuck and not going anywhere. If these proposals are genuine then this might be the best use of the bank’s funds, rather than stepping in and helping deals that would likely close anyway.

Read Full Post »

The VIE world certainly got a big shakeup yesterday by the SEC investigation of EDU. It has caused all manner of questions, both new and old to start flying through the air, and another shift in the risk assessment of the structure has ensued.

Essential reading about the issue can be found, as ever, on the China Accounting Blog, that lays out what happened:

New Oriental Education and Technology Group (NYSE: EDU) dropped a bombshell in its fourth quarter earnings release this morning. The company reported that the SEC has issued a formal order of investigation captioned “In the Matter of New Oriental Education & Technology Group Inc.” The Company believes that the investigation concerns whether there is a sufficient basis for the consolidation of Beijing New Oriental Education & Technology (Group) Co., Ltd., a variable interest entity of the Company, and its wholly-owned subsidiaries, into the Company’s consolidated financial statements.

Investors are appropriately concerned. The stock is off 37% as I write this, with other companies with VIEs off by single digits. A formal investigation is far more serious than the normal comment letter process that usually deals with these kinds of issues. It means the Division of Enforcement of the SEC, rather than the Division of Corporate Finance is dealing with the issue.  

On July 11 EDU announced it had restructured its VIE ownership. The VIE had been owned by a number of shareholders, some of whom are no longer active in the company.  It is now held by an entity owned by Chairman Michael Yu. I don’t see anything wrong with that restructuring. The SEC investigation was launched on July 13.  I doubt that the restructuring led to the investigation. I suspect that the company has been responding to the normal comment letters that the SEC Division of Corporate Finance issues to all companies periodically. Something may have gone terribly wrong in this process and the issue was referred to the Division of Enforcement, which launched a formal investigation.  That is all my speculation, however

Like Professor Gillis I am of the opinion that the restructuring of the company was nothing to get too riled up about, if anything it actually made the structure more stable. Even though there would need to be a reapplication to register the equity pledge because of the change in ownership. But, and this is fairly wild speculation, it’s entirely possible the SEC asked some questions regarding this shift and didn’t quite like the answers it got back.

The real impact of this move by the SEC is unclear at the moment, as we have no information about what exactly they are unhappy about. But it is fair to say that any concerns about consolidation of VIEs certainly has the potential to impact other companies that use the structure. Although SEC probes like this tend to be quite specific so the potential impact may indeed differ between companies. Not all VIEs are the same.

The key items at present for investors in other VIE companies are to assess their own situation. How much of the company is actually in the VIE (or: how much of the investment will just disappear from the balance sheet if consolidation is impossible), and then whether or not the potential issues the SEC has identified in EDU are likely to exist here as well. The last point will only become clear when we know the exact nature of the SEC investigation, but taking stock early will mean investors can move quickly on any new information supplied.

Read Full Post »

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.

Read Full Post »

A lot of people in China are looking to the Lashou IPO for a gauge on the temperature for China IPOs in the US. People were looking forward to seeing an increased US appetite for China concept stocks.

But as the IPO looks evermore likely to fall through, some will be inclined to conclude that interest in new Chinese IPOs is low. I’m not entirely certain we can go that far, but I do think we’ve learned some important lessons from the Lashou IPO process.

Firstly, there seems to be an increase in the amount of information that the SEC requires about VIE structures.

Previous disclosures have varied a lot in detail, and lacked some fundamental information that investors need to make informed decisions about the risks involved in the investment. Something that has arguably led to a mispricing of companies using VIE structures.

It now looks like the SEC wants to clean this up and give investors the information they need to properly judge the internal risks in the VIE structures.

I think this reform is much overdue and hope we will soon see an overhaul of the disclosures on the IFRS dictated exchanges with regards to VIEs as well (Predominantly Hong Kong and Singapore).

Secondly, there has been a very strong reaction to allegations of potential accounting issues at the company. This is hardly surprising when you consider the sheer amount of accounting frauds that have been uncovered in Chinese companies the last year.

We’ll have to see what comes of these allegations but investors have had their fingers burnt before so they will approach any company with rumoured accounting issue carefully.

In short, any Chinese company looking to IPO in the future had better get their act together on these two fronts before they file, as they are likely to face more scrutiny than before.

However, I think the real reason for the IPO issues might be found in the prospectus itself, rather than in the overall sentiment of the investors.

For instance, the company is operating in an industry where it has literally thousands of competitors, and this has forced the company’s margins down to a fraction of what we see in Groupon, for instance. So the financials themselves probably didn’t excite investors too much to begin with.

More alarmingly, the company’s biggest competitive edge over its competitors, its strong brand name, is in question, as the company does not own the trademark rights associated with it.

This could cause the company to loose the rights to its’ brand name as well as the rights to the website lashou.com, which would likely force the company to rebrand and start over from the beginning.

However, as Jiayuan managed an IPO not long ago under similar circumstances (they didn’t own the trademark rights to their brand either), we must conclude that something has changed.

I would argue, however, that what we’re seeing here isn’t a cooling off in the general interest in China concept stocks. Instead, we’re seeing investors becoming significantly less forgiving when it comes to discrepancies and issues in Chinese companies, but this should not be mistaken for a cooling interest in China as a whole.

We’ll have to wait until we see the prospectus for the rumoured Vancl IPO, and how well it is received by investors before we draw any definitive conclusions. But companies seem likely to face unabated, if more demanding, investor interest.

Read Full Post »

Today I’d like to go through some of the interesting points which have been raised regarding VIEs these past few days. Even though there has been a lack of new developments there have been many thoughtful views expressed. While I assume most of my readers would have read these excellent posts already I’ll go through some of them before offering my own thoughts on this very interesting topic.

Let’s start with the perceived difference in opinion between Bill Bishop at Digicha, and the people at China Law Blog.

Bill starts his discussion based on this bloomberg article, which we were both interviewed for it appears. His main point is:

… overall I believe the VIE issue is overstated and being kept in the news in part by lawyers using scare tactics to market their services and by investors talking up their short positions. There are many reasons to be cautious about the risks related to China investing, but the VIE issue is not nearly the most important.

Compared to which Steve Dickinson at the China Law blog offered this view on the latest VIE developments:

None of this is actually new. These risks have long been known. However, the clarity of the Regulations means it is now nearly impossible to claim that Chinese law on these issues is ambiguous or unclear. Where Chinese law says that ownership by foreigners is restricted or prohibited, the law means what it says.  Foreigners who invest in violation of the law are making a bet that the violation will be ignored. This is extremely unlikely in today’s China. Such bets are sucker’s bets and should avoided at all costs.

Seemingly hard to consolidate these views, impossible some might say, but Stan Abrams from China Hearsay offers an insight into where the real difference actually lies:

So, at first glance, two very different views, and I bet they would get into a serious argument if the opportunity arose. But I actually think that their fundamental conclusions are both right but are merely coming at the issue from two very different perspectives. Bill is a Internet and finance guy, and is looking at the market, firms’ access to capital, and what the government is likely to do.

Steve, on the other hand, is a corporate lawyer. He is looking at potential risk, at what might go wrong, and what is/is not a technical violation of the law.

When Bill says that we shouldn’t worry about the government going after Chinese listed firms in the U.S. that use the VIE structure, I think he’s right. All the inside chatter on that issue seems to indicate that the government will grandfather in those companies even if it adopts a new enforcement strategy.

And when Steve says that VIEs are rubbish, he’s of course right. These things are illegal in that their purpose is to deliberately skirt foreign investment restrictions. I don’t actually agree with him on what the M&A rules mean (I think it’s too early to tell), but I definitely agree with his overall legal opinion.

Stan also goes on to talk about the general enforceability of the contracts as the main risk in VIEs, and here I couldn’t agree more. In fact, it seems like everyone is pretty much in agreement that the risk of a general government clampdown on listed VIEs is extremely unlikely, the danger lies more towards a GigaMedia-like issue where the enforceability of contracts becomes the main sticking point.

But does this really mean that listed companies with VIE structures won’t be affected by this at all?

Dan Harris has this to say regarding the issue of enforceability:

Whether or not existing VIEs are shut down (and at this stage we tend to agree with Bishop that they generally very likely will not be), the reality is that they have now been deemed illegal and that cannot help but have a major and game-changing impact on them. As mentioned above, VIEs are a structure that allows foreign companies to control the Chinese entity via various contracts. Now that those various contracts have been declared illegal, it will be difficult/impossible to enforce those contracts in Chinese courts. In this VIE structures, many of the contracts involve foreign countries and foreign country enforcement so their illegality in China may be minimized to that extent. However, even outside China, the party seeking to avoid enforcement of a contract will, in many cases, still be able to argue against enforcement based on China’s having made the structure illegal.

Here’s where I think the real issue lies, but I don’t think it’s entirely confined to future deals and PE/VC investors. This could for all intents and purposes have a deeply negative impact for listed companies as well.

In order to consolidate VIEs one has to show that the listed company not only receives the economic benefits and takes the economic risks of the venture, a second condition is to show that the VIE is in fact controlled by the listed company. If the contracts, which are put in place to establish this control, are indeed deemed illegal and unenforceable, fulfilling the second part of the consolidation requirement becomes decidedly more difficult.

Read Full Post »

Older Posts »