Month: January 2011

In Full Agreement

Leave a Comment / January 27, 2011

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I commend unreservedly the following article from today’s Wall Street Journal editorial page. It discusses US reverse mergers and OTCBB IPOs for Chinese companies, identifying reasons these deals happen and the harm that’s often done.


What’s Behind China’s Reverse IPOs?


A dysfunctional financial system pushes companies toward awkward deals in America.
By JOSEPH STERNBERG

As if China Inc. didn’t already have enough problems in America—think safety scares, currency wars, investment protectionism and Sen. Chuck Schumer—now comes the Securities and Exchange Commission. Regulators are investigating allegations of accounting irregularities at several Chinese companies whose shares are traded in America thanks to so-called reverse mergers. Regulators, and not a few reporters, worry that American investors may have been victims of frauds perpetrated by shady foreign firms.

Allow us to posit a different view: Despite the inevitable bad apples, many of the firms involved in this type of deal are as much sinned against as sinning.

In a reverse merger, the company doing the deal injects itself into a dormant shell company, of which the injected company’s management then takes control. In the China context, the deal often works like this: China Widget transfers all its assets into California Tallow Candle Inc., a dormant company with a vestigial penny-stock listing left over from when it was a real firm. China Widget’s management simultaneously takes over CTC, which is now in the business of making widgets in China. And thanks to that listing, China Widget also is now listed in America.

It’s an odd deal. The goal of a traditional IPO is to extract cash from the global capital market. A reverse merger, in contrast, requires the Chinese company to expend capital to execute what is effectively a purchase of the shell company. The company then hopes it can turn to the market for cash at some point in the future via secondary offerings.

Despite its evident economic inefficiencies, the technique has grown popular in recent years. Hundreds of Chinese companies are now listed in the U.S. via this arrangement, with a combined market capitalization of tens of billions of dollars. Some of those may be flim-flammers looking to make a deceitful buck. But by all accounts, many more are legitimate companies. Why do they do it?

One relatively easy explanation is that the Chinese companies have been taken advantage of by unscrupulous foreign banks and lawyers. In China’s still-new economy with immature domestic financial markets, it’s entirely plausible that a large class of first-generation entrepreneurs are relatively naïve about the art of capital-raising but see a listing—any listing—as a point of pride and a useful marketing tool. There may be an element of truth here, judging by the reports from some law firms that they now receive calls from Chinese companies desperate to extract themselves from reverse mergers. (The news for them is rarely good.)

More interesting, however, is the systemic backdrop against which reverse mergers play out. Chinese entrepreneurs face enormous hurdles securing capital. A string of record-breaking IPOs for the likes of Agricultural Bank of China, plus hundred-million-dollar deals for companies like Internet search giant Baidu, show that Beijing has figured out how to use stock markets at home and abroad to get capital to large state-owned or well-connected private-sector firms. The black market can deliver capital to the smallest businesses, albeit at exorbitant interest rates of as much as 200% on an annual basis.

The weakness is with mid-sized private-sector companies. Bank lending is out of reach since loan officers favor large, state-owned enterprises. IPOs involve a three-year application process with an uncertain outcome since regulators carefully control the supply of new shares to ensure a buoyant market. Private equity is gaining in popularity but is still relatively new, and the uncertain IPO process deters some investors who would prefer greater clarity about their exit strategy. In this climate, it’s not necessarily a surprise that some impatient Chinese entrepreneurs view the reverse merger, for all its pitfalls, as a viable shortcut.

So although the SEC investigation is likely to attract ample attention to the U.S. investor- protection aspect of this story, that is the least consequential angle. Rules (even bad ones) are rules. But these shares are generally held by sophisticated hedge-fund managers and penny-stock day traders who ought to know that what they do is a form of glorified gambling.

Rather, consider the striking reality that some 30-odd years after starting its transformation to a form of capitalism, China still has not figured out one of capitalism’s most important features: the allocation of capital from those who have it to those who need it. As corporate savings pile up at inefficient state-owned enterprises, potentially successful private companies find themselves with few outlets to finance expansion. If Beijing can’t solve that problem quickly, a controversy over some penny stocks will be the least of anyone’s problems.

Mr. Sternberg is an editorial page writer for The Wall Street Journal Asia.

Toiling from Tang Dynasty to Today – Buying a House in Beijing

1 Comment / January 13, 2011

sancai16

How long would it take an ordinary Chinese peasant to save up and buy a nice apartment in Beijing? You’ll need to brush up on your dynastic history.

1,400 years ago, as the Tang Dynasty dawned in China, a peasant began farming a small plot of decent land 6mu (one acre) in size. Every year, in addition to providing for his family’s needs, he was able to earn a small profit by selling his surplus. His son followed him on the land, and maintained his father’s steady output and steady profit. Same with is children, and children’s children, through the Song, Yuan, Ming, Qing Dynasties into the Republican period and then the modern era marked by the founding of the People’s Republic in 1949, down to present day.

Some 280 generations later, there should now be just about enough in the family bank account for the family to pay cash for a new two-bedroom apartment in Beijing. This is assuming no withdrawals from the bank account during that time, and even more unlikely, no bad years due to floods, famine, locusts, rebellion.

I heard this calculation second hand, and so can’t check the figures. But, it certainly has a ring of truth about it. Property prices in Beijing particularly, but other large cities as well, have reached levels utterly disconnected from average earning levels, especially in rural China.  New apartments can now cost over USD$1 million. Prices continue to rise by over 5% a month, despite aggressive actions by government to curb the increases in residential property prices. According to the Wall Street Journal, “Housing prices in the U.S. peaked at 6.4 times average annual earnings this decade. In Beijing, the figure is 22 times.”

The collapse of this “housing price bubble” has been widely predicted for years now  — not since the Tang Dynasty, but it sometimes seems that way. The housing price crash was meant to be imminent two years ago, when prices were about 30% of current levels.

Still, they keep rising, most recently and most dramatically in second and third tier cities in China, places like Lanzhou, a provincial capital in arid Western China, where the cost of a 100 square meter apartment has doubled in price in the last year, to about $300,000.  Some apartment owners in Lanzhou earned as much profit  during 2010 from the sale of their property as a typical peasant in surrounding Gansu Province might make in a century.

My prediction is that housing prices may soon peak relative to incomes, but will keep moving upward. There are a few fundamental factors at work that raise the altitude of housing prices: rising affluence, China’s continuing urbanization and a dearth of alternative investment opportunities. Real estate, despite what can seem like dizzying price levels, is often seen to be a safer long-term bet than buying domestically-quoted shares.

Introducing property taxes, and allowing ordinary Chinese to buy assets outside China, would both alter the balance somewhat.  But, many a hard-working peasant is still going to need a thousand years of savings to join the propertied classes in Beijing.


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US Government Acts to Police OTCBB IPOs and Reverse Mergers for Chinese Companies

1 Comment / January 5, 2011

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In my experience, there is one catastrophic risk for a successful private company in China. Not inflation, or competition, or government meddling. It’s the risk of doing a bad capital markets deal in the US, particularly a reverse merger or OTCBB listing.  At last count, over 600 Chinese companies have leapt off these cliffs, and few have survived, let alone prospered. Not so, of course, the army of advisors, lawyers and auditors who often profit obscenely from arranging these transactions.

Not before time, the US Congress and SEC are both now finally investigating these transactions and the harm they have done to Chinese companies as well as stock market investors in the US. Here is a Chinese language column I wrote on this subject for Forbes China: click here to read.

As an American, I’m often angry and always embarrassed that the capital market in my homeland has been such an inhospitable place for so many good Chinese companies. In fact, my original reason for starting China First Capital over two years ago was to help a Jiangxi entrepreneur raise PE finance to expand his business, rather than doing a planned “Form 10” OTCBB.

We raised the money, and his company has since quadrupled in size. The founder is now planning an IPO in Hong Kong later this year, underwritten by the world’s preeminent global investment bank. The likely IPO valuation: at least 10 times higher than what was promised to him from that OTCBB IPO, which was to be sponsored by a “microcap” broker with a dubious record from earlier Chinese OTCBB deals.

In general, the only American companies that do OTCBB IPOs are the weakest businesses, often with no revenues or profits. When a good Chinese company has an OTCBB IPO, its choice of using that process will always cast large and ineradicable doubts in the mind of US investors. The suspicion is, any Chinese entrepreneur who chooses a reverse merger or OTCBB IPO either has flawed business judgment or plans to defraud his investors. This is why so many of the Chinese companies quoted on the OTCBB companies have microscopic p/e multiples, sometimes less than 1X current year’s earnings.

The US government is finally beginning to evaluate the damage caused by this “mincing machine” that takes Chinese SME and arranges their OTCBB or reverse mergers. According to a recent article in the Wall Street Journal, “The US Securities and Exchange Commission has begun a crackdown on “reverse takeover” market for Chinese companies. Specifically, the SEC’s enforcement and corporation-finance divisions have begun a wide-scale investigation into how networks of accountants, lawyers, and bankers have helped bring scores of Chinese companies onto the U.S. stock markets.”

In addition, the US Congress is considering holding hearings. Their main goal is to protect US investors, since several Chinese companies that listed on OTCBB were later found to have fraudulent accounting.

But, if the SEC and Congress does act, the biggest beneficiaries may be Chinese companies. The US government may make it harder for Chinese companies to do OTCBB IPO and reverse mergers. If so, then these Chinese firms will need to follow a more reliable, tried-and-true path to IPO, including a domestic IPO with CSRC approval.

The advisors who promote OTCBB IPO and reverse mergers always say it is the fastest, easiest way to become a publicly-traded company. They are right. These methods are certainly fast and because of the current lack of US regulation, very easy. Indeed, there is no faster way to turn a good Chinese company into a failed publicly-traded than through an OTCBB IPO or reverse merger.


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