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.


EDUs SEC Troubles

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.

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.

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.

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.

A report in the Chinese press has outlined yet another instance of the government criticising VIEs and foreign influence in sensitive sectors.

While this might not sound as news it has two features that sets it apart from the average criticism. It is supposedly the opinions of some fairly senior people in the central government, and it outlines a potential course of action to bring current business practices more in line with official law and policy.

Although generally vague there are two features relating to the scrutiny of VIEs that offer some interesting insights into how enforcement around the issue could look. Something that should be of interest to investors seeking to understand risk exposure in the area.

  1. Talks about scrutinising all contracts between domestic and foreign companies in these restricted industries.
  2. Examining the suitability of the foreign partner in these contracts

The reason this is interesting is that it sets out a potential focus of enforcement that is different from what some thought it would be. For instance there’s no direct attack on the VIE concept, but rather a slower approach that starts with scrutinising the contracts involved and the companies that have signed them.

This is important as it shifts the focus from the structure as a whole into its individual parts, and as such opens up for treating different VIEs differently. This type of action looks a lot like trying to pick off some low hanging fruit in the industry, which in this case would likely mean some of the poorer constructed VIEs.

As I have mentioned before there are big differences between one VIE structure and another, ranging from how much of the assets are kept in the VIE to how they have formulated the contracts used to extract the money into the WFOE. These factors will take on a new importance if this type of action is implemented.

For instance, if the government was to start scrutinising the contracts used in VIE structures they will find that some of the technical services agreements have terms that can by no means be referred to as “at arms length”. Some of these agreements stipulate that the VIE is to pay all of its revenues as fees for services rendered by the WFOE, as well as any residual profit at the end of the year. While this contract might be good from a consolidation standpoint it is an absolute nightmare from a transfer pricing point of view, and leaves the company open to some very serious tax liabilities.

Increased scrutiny of the WFOE used in the deal offers another set of potential problems. With some of these companies holding virtually their entire operations in the VIE it could be hard to argue how the WFOE is providing services of enough value to receive all the profits from the VIE. Another potential issue that could arise is questions of whether the WFOE is acting outside its business scope, for instance when it provides loans to capitalise the VIE.

This type of enforcement, if enacted, is not so much an attack on VIEs as a tightening of the screws surrounding the structure. While well-constructed VIEs may walk away unscathed some lower quality arrangements could get in very real and costly trouble. Investing on this information will be all about being able to tell a good VIE from a bad one, which will require looking over the details of your investment structure before the Chinese government does.

With last years going private boom among the US-listed Chinese companies in a lull we have some time to reflect on the potential aftermath.

There was quite a bit written about the going private opportunity at the time, mostly implying that the current valuations were far too low and that a de-list re-list deal taking the company from the US to Asia could yield quick returns. A promise that appears to have intrigued any number of PE firms to take a closer look at this type of deal.

The problem with this type of investment, which was also pointed out at the time, is that it usually requires another IPO exit, which at the moment is a lot easier said than done. This is creating issues for foreign PE firms currently finding out just how hard-accomplished exits are in China these days.

As was pointed out in an excellent piece on the China Private Equity blog, the domestic IPO market is tightly controlled, backed up and dominated by a few domestic firms who appear to hold the keys to the door. Also, Hong Kong is getting stricter on who they allow in, especially on VIE listings that need to provide a lot more these days, and the M&A market is still so small that it cannot be counted on to pick up much of the slack.

There are of course measures the companies can still take to increase the value of their investment, rebuilding the investment structure is one such example, but in such a stale market it will still be hard to find viable exit options.

In fact, it appears the industry has now taken some measures to try to remedy the situation itself. One such instance is the new occurrence of PE firms exiting deals to other PE firms, which begs the question of where these new owners are expecting to find an exit that their colleagues missed. We also have an interesting addition of buy-back clauses in the investment contracts that would potentially require the company to buy back the shares the PE firm took for a set yearly ROI rate.

This last measure appears particularly strange, as it does not detail where the money to buy back the shares should come from, or what enforcement mechanisms the company has at its disposal. It would seem ill advised for the PE firm to try to enforce its’ claim and make the company sell off assets etc. to pay back the investment potentially crippling a well-functioning company. The PE industry isn’t popular to begin with and such a move would certainly hurt the industry as a whole.

Overall the industry seems to be in some state of collective hibernation, with a reported $50 billion invested, and another $50 billion waiting in the wings there needs to be viable exit options available. At present you’d be hard pressed to find even one reliable exit for the industry, and even when the market starts moving in the right direction PE firms are likely to find tougher demands on what will be let through this time around.