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.
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Deloitte’s China woes have gone from bad to worse.
Latest Muddy Waters target Focus Media (FMCN) is yet another company with serious fraud allegations leveled against them which was audited by Deloitte. Something that has led to serious suspicions against the auditors themselves.
The company was already in trouble with American authorities following the Longtop scandal and its aftermath, where they were unable to help in the on-going investigations against the fraudulent company. Should these latest fraud allegations be proven correct, and yet another client of the company found guilty of fraudulent activities, American authorities and investors will not stay silent.
Being audited by Deloitte is becoming a burden for Chinese companies, as the markets have lost so much confidence in the auditor that all of Deloitte’s clients are suspects by association. Deloitte-audited Chinese companies are traded at a discount by some investors, government authorities are increasing their scrutiny of them, and short sellers are looking at them specifically for potential short cases.
Trying to pitch clients on the idea of trading at a discount and facing extra scrutiny from authorities and shorts will make it exceedingly hard for Deloitte to maintain its current market position. This will be especially true for the IPO market where Chinese companies are already facing increased scrutiny from the SEC, which means companies are unlikely to want to add even more potential issues to their offering.
Deloitte needs to move fast to regain the confidence of the market if they want to stay competitive in China, but this will likely be neither easy nor cheap to accomplish.
In fact, the situation has deteriorated to a point where there might have to be a token leadership change at the top, followed by a purge of the company’s entire China operations to indicate that the company is serious about getting to grips with the situation.
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Just a quick update:
according to a China Daily article the PCAOB and CSRC met during the US-China Strategic and Economic Dialogue last month, and decided to increase their efforts to close the regulatory loopholes in accounting between the two countries.
Professor Paul Gillis talked about these issues over at the China Accounting Blog, and I would imagine him to be a strong candidate to consult on the issue.
This bodes well for the future as it should make certain frauds significantly harder to accomplish, however, I have a feeling this collaboration will also have an effect in “outing” a few more companies. It could also speed up the rate at which short sellers are issuing reports on Chinese frauds.
Overall we’re seeing a good amount of growth in the “DD-to-short” sector, I suspect based on the success of Muddy Waters and citron research in bringing down some big guns. But if the regulatory loopholes go away, and we can look forward to overall better quality filings from Chinese companies, now is the time to find the frauds early, short them, and publish your findings.
Will we be seeing a frenzy in this market now before the job likely gets much harder?
All in all exciting times ahead!
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