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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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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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.
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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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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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Posted in China Finance, China Investment, VIE structures, tagged China fraud, Frazer Frost, JGBO, Jiangbo, SAFE regulations, US-listed Chinese companies, VIE, VIE risk, VIE structures on June 2, 2011|
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Recently trading stopped on shares of Jiangbo Pharma, because the SEC wants some more information from the company. I have yet to see a good report on exactly what information has been requested, however.
This in itself is no great surprise, the company is reverse listed and used to be audited by the shorters favourite Frazer Frost, which is by now almost synonymous with fraud allegations and delistings.
What is more interesting is that on the face of it, the investment in the company still doesn’t seem so bad, as the market cap of the company was around 42 million while it held cash of 146 million (assuming we can trust the books on this). Thisseems like an odd thing to have happen until you look through their corporate structure and find that basically all of the company’s assets is sitting in the VIE for no apparent reason.
I doubt that this is what the market has been pricing the company for, however, it seems more likely that the market assumed fraudulent books and overstated profits/cash positions. But nevertheless investors could quickly learn just how much 146 million in a VIE could be worth if the owner decides to pack it up.
JGBO’s structure is a very simple VIE arrangement with the entire operating part of the company in the VIE. It should be noted that there is no legal reason for the entire company to be run as a VIE, some areas are restricted but much of it could reasonably be run through a WFOE.
Even though all of the normal contracts are in place the company appears unwilling to transfer any of their assets out of the VIE, even to the extent that they failed to make their interest payments/penalties on convertible notes in the US due to an inability to transfer money out of the VIE.
If the contracts that they claim to have are in place the money should, at the very least, be able to travel to the WFOE without much hassle or expense. Even if transferring it out of China does require SAFE approval, SAFE approval is not a valid excuse for holding all of the company’s assets in a legally questionable VIE arrangement without any security for the investors.
The company seems to be making up excuses for why the money should stay in the VIE, where the investors have questionable control over it. If this turns into a legal case involving fraud my guess is that investors will come to the stark realisation that 146 million in cash stashed in a VIE might well be worth nothing at all.
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Posted in China Finance, China Investment, tagged Alibaba, Alipay, China Finance, China Investment, US-listed Chinese companies, VIE, VIE structures, Yahoo on May 22, 2011|
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The big news in Chinese-American finance this week has undoubtedly been the Yahoo vs. Alibaba spat.
If you haven’t read about it, you should!
The basics are that Alibaba transferred its profitable Alipay business (Chinese paypal) to a company controlled by Jack Ma, and Simon Xie founders of Alibaba. And now this transfer has resulted in de-consolidation of the company from Yahoos investment in Alibaba. This all came to light this year and Yahoo claim to have had no prior knowledge of this, even though they had board representation in Alibaba.
Now what’s interesting is that it appears as if 70% of the company was transferred in 2009, meaning that there would have had to be a VIE agreement in place for it to stay consolidated even at that point. Which means that the transfer of all the remaining ownership to this new structure should not have had any impact at all, it would merely be 100% VIE.
So the question really is, why did it suddenly de-consolidate?
As we have very little info to go on here it’s very hard to have any type of certainty in the predictions or warnings we get from this example. However, the current debate seems to be talking about the wrong thing.
The fact that the company transferred its ownership to a Chinese entity is not the issue, they avoided a lot of regulation by using a VIE structure, nothing strange about that.
The question investors need to be asking themselves is why, and how, the VIE structure disappeared. This could be the definitive proof of just how risky the VIE structure actually is, but as we have no information of how it was structured it’s hard to say anything for certain.
If we assume that the VIE was set up in the normal fashion then something must have happened with the contractual agreements between Alibaba’s subsidiaries and Alipay. What exactly happened is impossible to say at present, but regardless of what it was it raises some very poignant questions about the issues of VIE contracts. All we know currently is that a VIE has simply walked off the consolidated financial statements without an explanation, this in itself should be enough for anyone investing in VIE companies to start asking some serious questions.
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