delist-relist

China to fine-tune back-door listing policies for US-listed companies — South China Morning Post

 

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China reverse mergers

Mainland China’s securities regulator will fine-tune policies related to back-door listing (reverse merger)attempts by US-listed Chinese companies, industry insiders say, but it is unlikely to ban them or impose other rigid restrictions.

“It is clear that the regulator does not like the recent speculation on the A-share markets triggered by the relisting trend and will do something to curb such conduct, but it seems impossible they would shut good-quality companies out of the domestic market,” Wang Yansong, a senior investment banker based in Shenzhen, said.

The China Securities Regulatory Commission (CSRC) was considering capping valuation multiples for companies seeking relisting on the A-share market after delisting from the US market, Bloomberg reported on Tuesday. Another option being discussed was introducing a quota to limit the number of reverse mergers each year from companies formerly listed on a foreign bourse.

To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals
Wang Yansong.

However, Wang said the CSRC was more likely to strengthen verification of back-door listing deals on a case-by-case basis.

“To curb speculation, it is most important to show the authorities have clear and strict standards for approving these deals, and won’t allow poor-quality companies to seek premiums through this process,” she said.

US-listed mainland companies have been flocking to relist on the A-share market since early last year, when the domestic market started a bull run, in order to shed depressed valuations in American markets.

The valuations of relisted companies have boomed, and that has triggered a surge in speculation on possible shell companies – poorly performing firms listed on the Shanghai or Shenzhen bourses. In a process called a reverse takeover or back-door listing, a shell can buy a bigger, privately held company through a share exchange that gives the private company’s shareholders control of the merged entity.

The biggest such deal was done by digital advertising company Focus Media. Its valuation jumped more than eightfold to US$7.2 billion after it delisted from America’s Nasdaq in 2013 and relisted in Shenzhen in December last year, with private equity funds involved in the deal reaping lucrative returns.

Peter Fuhrman, chairman of China First Capital, an investment bank and advisory firm, said the trend of delisting and relisting was “one of the biggest wealth transfers ever from China to the US”.

“The money spent by Chinese investors to privatise Chinese companies in New York ended up lining the pockets of rich institutional investors and arbitrageurs in the US,” he said.

However, a tightening or freeze on approval of such deals would threaten not only US-listed Chinese companies in the process of buyouts and shell companies, but also the buyout capital sunk into delistings and relistings.

“The more than US$80 billion of capital spent in the ‘delist-relist’ deals is perhaps the biggest unhedged bet made in recent private equity history … if, as seems true, the route to exit via back-door listing may be bolted shut, this investment strategy could turn into one of the bigger losers of recent times,” he said.

On Friday, CSRC spokesman Zhang Xiaojun sidestepped a question about a rumoured ban on reverse takeover deals by US-listed Chinese companies in the A-share market, saying it had noticed the great price difference in the domestic and the US markets, and the speculation on shell companies, and was studying their influences.

http://www.scmp.com/business/markets/article/1943386/china-fine-tune-back-door-listing-policies-us-listed-companies

For article on a related topic published in “The Deal”, please click here

 

How Renminbi funds took over Chinese private equity (Part 2) — SuperReturn Commentary

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How Renminbi funds took over Chinese private equity

(Part 2)

 
Large and small ships traverse the Huangpu River 24 hours a day, 7 days a week, and 365 days a year.

Part two of a series. Read part one.

Gresham’s Law, as many of us were taught a while back, stipulates that bad money drives out good. There’s something analogous at work in China’s private equity and venture capital industry. Only here it’s not a debased currency that’s dominating transactions. Instead, it’s Renminbi private equity (PE) firms. Flush with cash and often insensitive to valuation and without any clear imperative to make money for their investors, they are changing the PE industry in China beyond recognition and making life miserable for many dollar-based PE and venture capital (VC) firms.

Outbid, outspent and outhustled

From a tiny speck on the PE horizon five years ago, Reminbi (RMB) funds have quickly grown into a hulking presence in China. In many ways, they now run the show, eclipsing global dollar funds in every meaningful category – number of active funds, deals closed and capital raised. RMB funds have proliferated irrespective of the fact there have so far been few successful exits with cash distributions.

The RMB fund industry works by a logic all its own. Valuations are often double, triple or even higher than those offered by dollar funds. Term sheets come in faster, with fewer of the investor preferences dollar funds insist on. Due diligence can often seem perfunctory.  Post-deal monitoring? Often lax, by global standards. From the perspective of many Chinese company owners, dollar PE firms look stingy, slow and troublesome.

The RMB fund industry’s greatest success so far was not the IPO of a portfolio company, but of one of the larger RMB general partners, Jiuding Capital. It listed its shares in 2015 on a largely-unregulated over-the-counter market called The New Third Board. For a time earlier this year, Jiuding had a market cap on par with Blackstone, although its assets under management, profits, and successful deal record are a fraction of the American firm’s.

The main investment thesis of RMB funds has shifted in recent years. Originally, it was to invest in traditional manufacturing companies just ahead of their China IPO. The emphasis has now shifted towards investing in earlier-stage Chinese technology companies. This is in line with China’s central government policy to foster more domestic innovation as a way to sustain long-term GDP growth.

The Shanghai government, which through different agencies and localities has become a major sponsor of new funds, has recently announced a policy to rebate a percentage of failed investments made by RMB funds in Shanghai-based tech companies. Moral hazard isn’t, evidently, as high on their list of priorities as taking some of the risk out of risk-capital investing in start-ups.

Dollar funds, in the main, have mainly been observing all this with sullen expressions. Making matters worse, they are often sitting on portfolios of unexited deals dating back five years or more. The US and Hong Kong stock markets have mainly lost their taste for PE-backed Chinese companies. While RMB funds seem to draw from a bottomless well of available capital, for most dollar funds, raising new money for China investing has never been more difficult.

RMB funds seldom explain themselves, seldom appear at industry forums like SuperReturn. One reason: few of the senior people speak English. Another: they have no interest or need to raise money from global limited partners. They have no real pretensions to expand outside China. They are adapted only and perhaps ideally to their native environment. Dollar funds have come to look a bit like dinosaurs after the asteroid strike.

Can dollar-denominated firms strike back?

Can dollar funds find a way to regain their central role in Chinese alternative investing? It won’t be easy. Start with the fact the dollar funds are all generally the slow movers in a big pack chasing the same sort of deals as their RMB brethren. At the moment, that means companies engaged in online shopping, games, healthcare and mobile services.

A wiser and differentiated approach would probably be to look for opportunities elsewhere. There are plenty of possibilities, not only in traditional manufacturing industry, but in control deals and roll-ups. So far, with few exceptions, there’s little sign of differentiation taking place. Read the fund-raising pitch for dollar and RMB funds and, apart from the difference in language, the two are eerily similar. They sport the same statistics on internet, mobile, online shopping penetration: the same plan to pluck future winners from a crop of look-alike money-losing start-ups.

There is one investment thesis the dollar PE funds have pretty much all to themselves. It’s so-called “delist-relist” deals, where US-quoted Chinese companies are acquired by a PE fund together with the company’s own management, delisted from the US market with the plan to one day IPO on China’s domestic stock exchange. There have been a few successes, such as the relisting last year of Focus Media, a deal partly financed by Carlyle. But, there are at least another forty such deals with over $20bn in equity and debt sunk into them waiting for their chance to relist. These plans suffered a rather sizeable setback recently when the Chinese central government abruptly shelved plans to open a new “strategic stock market” that was meant to be specially suited to these returnee companies. The choice is now between prolonged limbo, or buying a Chinese-listed shell to reverse into, a highly expensive endeavor that sucks out a lot of the profit PE firms hoped to make.

Outspent, outbid and outhustled by the RMB funds, dollar PE funds are on the defensive, struggling just to stay relevant in a market they once dominated. Some are trying to go with the flow and raise RMB funds of their own. Most others are simply waiting and hoping for RMB funds to implode.

So much has lately gone so wrong for many dollar PE and VC in China. Complicating things still further, China’s economy has turned sour of late. But, there’s still a game worth playing. Globally, most institutional investors are under-allocated to China.  A new approach and some new strategies at dollar funds are overdue.

Peter Fuhrman moderates our SuperReturn China 2016 Big Debate: ‘How Do You Best Manage Your Exposure To China?’. Discussants include:

  • John Lin, Managing Partner, NDE Capital (GP)
  • Xisheng Zhang, Founding Partner & President, Hua Capital (GP)
  • Bo Liu, Chief Investment Officer, Wanda Investment (LP)
The Big Debate takes place on Tuesday 19 April 2016 at 11:55 – 12:25 at SuperReturn China in Beijing. Can’t make it? Follow the action on Twitter.

WH Group Hong Kong IPO Goes Belly Up – Leaving Wall Street’s Most Famed Investment Banks and Some of Asia’s Biggest PE Firms at an Embarrassing Loss

WSJ Shuanghui WH Group failed IPO

There will be an awful lot of embarrassed financial professionals sulking around Hong Kong and Wall Street today. The reason: a crazy IPO deal financially-engineered by a group of 29 big name investment banks, led by Morgan Stanley, together with several large China and Asian-based PE firms including China’s CDH and Singapore’s Temasek Holdings failed to find investors. Their pig’s ear didn’t, as they promised, turn into the silk purse after all. The planned IPO of WH Group has been aborted.

WH Group was created by the banks and PE firms to hold the assets of American pork producer Smithfield Foods bought last year in a leveraged buyout. The other asset inside of WH Group is a majority shareholding in China’s largest pork company Henan Shuanghui Investment & Development.

I was one of the few who actually called into question almost a year ago the logic as well as the economics of the deal. You can read my original article here.

There weren’t a lot of other doubters at the time. The mainstream financial press, by and large, went along with things, accepting at face value the story provided to them by Morgan Stanley, CDH and others. Over the last few months, as the now-failed IPO got into gear in anticipation of closing the deal around now, the press kept up its steady reporting, not raising too many tough questions about what were obviously some glaring weak points – the high debt, the high valuation, the crazy corporate structure that made the deal appear to be what it wasn’t, a Chinese takeover of a big US pork company.

I have no special interest in this deal, since me and my firm never acted for any of the parties involved, nor do I own any shares in any of the companies involved. I just couldn’t get over, in reading the SEC documents filed at the time of the takeover, the brazenness of it, the chutzpah, that these big institutions seemed to be betting they could repackage a pound of sausage bought in New York for $1 as pork fillet and sell it for $5 to Hong Kong investors and institutions.

In other words, saying at the time it looked like the whole thing rested on a very shaky foundation was a reasonable conclusion for anyone who took the time to read the SEC filings. Instead, mainly what we heard about, over and over, was that this was (wrongly) China’s “biggest takeover of a US company,” a “merger between America’s largest pork producer and its counterpart in the world’s largest pork market.”

Morgan Stanley, CDH, Temasek and the others got a little too cocky. The original Smithfield “take private” deal last year went through smoothly. They moved quicker than originally planned to get the company re-listed in Hong Kong. Had they pulled it off, it would have meant huge fees for the investment bankers, and depending on the share price, a juicy return for the PE firms, most of whom had been stuck holding the shares in Henan Shuanghui Investment & Development for over seven years. First came word last week they wanted to cut back by 60% the size of the IPO due to the hostile reception from investors during the road show phase. Then the IPO was suddenly called off late on Tuesday, Hong Kong time.

One of the questions that never got properly answered is why these PE firms didn’t sell their Shuanghui shares on the Chinese stock market, but held them since IPO, without exiting. That’s unusual, especially since Shuanghui’s shares have traded well above the level CDH and others bought in at. I wasn’t in China at the time, but that original investment did not cover itself in praise and glory. Almost immediately after the PE firms went in, providing the capital to allow the state-owned Shuanghui to privatize itself in 2006, the rumors began to circulate that the deal was deeply corrupt, and for reasons never explained, was structured in a way where the PE firms did not have a way to exit through normal stock market channels.

The Smithfield acquisition never made much of any industrial sense. The PE firms that now own the majority (mainly CDH, Temasek, New Horizon, but also including Goldman Sachs’ Asia PE arm ) have no experience or knowledge how to run a pork business in the US. In fact, they don’t know how to run any business in the US. The Shuanghui China management, which is meant now to be serving two separate masters, simultaneously running the Chinese company and its troubled American cousin, similarly don’t know a hock from a snout when it comes to raising and selling pork in the US. This is, was and will remain the main business of Smithfield. Not exporting pork to China. How, when and why these US assets can be listed in Asia must certainly now count as a mystery to all of the big-name financial institutions involved, including Bank of China, which lent billions to finance the takeover last year, as did Morgan Stanley itself.

So, now we have this sorry spectacle of the PE firms, together with partners, having seemingly thrown more money away in a failed bid to rescue the original Shuanghui investment from its unexplained illiquidity. The WH Group IPO failure is also a stunning rebuke for the other PE-backed P2P take private deals now waiting to relist in Hong Kong. (Read here, here, here.) Smithfield, while no great shakes, is the jewel among the rather sorry group of mainly-Chinese companies taken private from the US stock exchange with the plan to sell them later to Hong Kong-based investors via an IPO.

This was among the most bloated IPOs ever, with 29 investment banks given underwriting mandates to sell shares. ( The IPO banks included not only Morgan Stanley, but also Citic Securities, Goldman Sachs, UBS, Barclays, Credit Suisse, JP Morgan, Nomura, Citigroup, Deutsche Bank.) All that expensive investment banking firepower. Result: among the most expensive IPO duds in history.

For the PE consortium that owns WH Group, they will have already likely lost over USD$15mn in LP money on legal, underwriting and accounting fees on this failed IPO. This is on top of a whopping $729mn fees paid by the PE firms for what are called “one-off fees and share-based payments” to acquire Smithfield. The subsequent restructuring ahead of IPO? Maybe another $100mn. If or when the WH Group IPO is tried again, the fees will likely be at least as high as the first time around. In short, the PE firms are already close to $1 billion in the red on this deal, not including interest payments on all the debt.  Smithfield itself remains lacklustre. Its net profit shrank 50% during the fiscal year leading up to the buyout.

With no IPO proceeds anywhere on the horizon, the issue looming largest now for the PE firms: is WH Group generating enough free cash to service the $7 billion in debt, including $4 billion borrowed to buy sputtering Smithfield? If not, next stop is Chapter 11.

By contrast, now feeling as delighted as pigs in muck are the mainly-US shareholders who last year sold their Smithfield shares at a 31% premium above the pre-bid price to the Chinese-led PE group. It doesn’t offset by much the US trade deficit with China, which reached a new record last year of $318 billion. But these US investors also get the satisfaction of knowing they have so far received the far better end of a deal against some of the bigger, richer financial institutions in Asia and Wall Street.

 

Investors Vs. Asset Managers: A Dysfunction at the Heart of China Private Equity

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Assuming the same level of risk, would you rather make $100 from investing $10 or from investing $50? Easy, right? Who wouldn’t choose to make ten times your money, rather than just double it? There is one group I know. Private equity firms active in China. At least some of them. They care more about the amount they can invest in a deal than the profits they stand to make.

The illogic at work here is the direct result of some particular, not very appealing characteristics,  of the PE industry in China. PE firms lately have more confidence in their ability to raise money than to invest it profitably by achieving a timely exit. To raise money, though, a PE firm needs first to spend most of what it already has. Result: a rush to get money out the door and parked in deals.

In industry parlance, “check size” is often more important than potential risk-adjusted returns.This is one reason for the recent rash of “take private” PtP deals of Chinese companies quoted in the US. (See previous articles, including here, here, here. ) The transactions seem to me ill-considered. PEs have invested billions of dollars in such deals but there is not a single successful example they can point to of such PtP deals done in the US making money for investors. This must be a PE industry first — so much LP money put at risk against an investment idea that is totally unproved.

Who’s most harmed from focus on “check size” over deal quality and prospective returns? Of course it’s the LPs whose money is put into these deals. They want and need high returns, not bigger deals done using their money to aid PE firms’ future fund-raising.

But, Chinese entrepreneurs also suffer in this environment, because many PE firms now simply won’t look at deals where they can’t invest at least $25mn for around 25% of the company. There are few deals out there in that size range, meaning deserving entrepreneurs can’t find investors.

The big picture here: PE in China has become more and more a business dominated by asset managers not investors. How to tell the two apart? An asset manager enjoys the comfort and certainty of making a steady 2% a year managing other people’s money. The more money they raise, the more money they keep. Good markets or bad, the money keeps rolling in.

An investor, on the other hand, is a whole different animal. They share some DNA with the entrepreneurs they back. They love the sport of finding and evaluating deals, spotting where big money can be made, putting money at risk. When it works, they make big sums for their investors, and keep a nice chunk themselves.

Needless to say, LPs give money to PE firms in hopes they have chosen investors not asset managers. PE firms know this, of course, and tailor their money-raising pitch accordingly. They stress their deal-making prowess, not the fact that over the life of a typical 10-year fund, an LP will start with a 20% cumulative loss, because of the typical annual management fee deductions.

In China, it used to be fairly easy to make money in PE. But, over the last three years, returns began to head south. More recently,  over the last 18 months, the performance has mainly been dismal, with few successful deals exiting with big profits. It’s getting harder and harder for LPs to make money in China PE, after those accumulated management fees have been deducted.

But, there’s a time lag — as well as an information asymmetry — at work here. While recent performance has been, on the whole, lousy, there’s still appetite among LPs to allocate more money to China. A big reason is that China’s economy, and capital markets, are both the second-biggest in the world. Most LPs are seriously underweight China and want to change that.

And so we arrive at the current paradoxical situation, where it’s still comparatively easier to collect money to invest in China than to make money deploying it. Now, of course, PE firms can only succeed in raising capital if they can point to some successful past deals. Here too there’s an information asymmetry at work. Many PE firms did well from 2005-2010, and so their fund-raising documents emphasize deals done during this era. But, the game has changed out of all recognition since then.

Few, if any, PE firms have shown they can continue to earn investors good money when markets become less accommodating. It’s no longer possible to play the game of valuation arbitrage, of investing in China deals at single digit p/e multiples, and exiting them soon after at 5-10 times higher multiples through an IPO.

Earning a profit on an investment takes preparation, luck and time. Making money by convincing people to pay you a fee to manage theirs, by contrast, is a much simpler proposition, as well as a no-lose one.

And so the gulf widens between the objectives of PE firms and the fiduciary responsibilities and performance goals of the institutions whose money they manage.

This can be a problem everywhere in the PE and VC industry, as well as more broadly wherever people get paid to manage assets owned by someone else. (See principal-agent dilemma.)   But, it’s probably especially pernicious in China PE.

The industry is staffed mainly be ex-investment bankers, who by background and temperament understand more about fee-based, than performance-based, compensation. Few have a background of actually managing a company, investing its capital to produce a return. Without this first-hand understanding, it’s far harder as an investor to plot how to make an operating business more valuable. The result: PE firms in China will often opt for an easier path: making money by raising money from, and managing for,  other financial professionals.

The Ambow Massacre — Baring Private Equity Fails in Its Take Private Plan

 

In the last two years, more than 40 US-listed Chinese companies have announced plans to delist in “take private” deals.  About half the deals have a PE firm at the center of things, providing some of the capital and most of the intellectual and strategic firepower. The PE firms argue that the US stock market has badly misunderstood, and so deeply undervalued these Chinese companies. The PE firms confidently boast they are buying into great businesses at fire sale prices.

The PE firm teams up with the company’s owner to buy out public shareholders, with the plan being at some future point to either sell the business or relist it outside the US. At the moment, PE firms are involved in take private deals worth about $5 billion. Some of the bigger names include Focus Media, 7 Days Inn, Simcere Pharmaceutical.

The ranks of “take private” deals fell by one yesterday. PE firm Baring Private Equity announced it is dropping its plan to take private a Chinese company called Ambow Education Holding listed on the New York Stock Exchange. Baring, which is among the larger Asia-headquartered private equity firms, with over $5 billion under management,  first announced its intention to take Ambow private on March 15. Within eleven days, Baring was forced to scrap the whole plan. Here’s how Baring put it in the official letter it sent to Ambow and disclosed on the SEC website, “In the ten days since we submitted the Proposal, three of the four independent Directors and the Company’s auditors have resigned, and the Company’s ADSs have been suspended from trading on the NYSE. As a result of these unexpected events, we have concluded that it is not possible for us to proceed with the Transaction as set forth in our Proposal.”

Baring’s original proposal offered Ambow shareholders $1.46 a share, a 45% premium over the price at the time. Baring is already a shareholder of Ambow, holding about 10% of the equity. It bought the shares earlier this year.  Assuming the shares do start trading again, Baring is likely sitting on a paper loss of around $8mn on the Ambow shares it owns, as well as a fair bit of egg on its face. Uncounted is the amount in legal fees, to say nothing of Baring’s own time, that was squandered on this deal. My guess is, this is hardly what Baring’s LPs would want their money being spent on.

Perhaps the only consolation for Baring is that this mess exploded before it completed the planned takeover of the company. But, still, my question, “what did Baring know about any big problems inside Ambow when it tabled its offer ten days ago?” If the answer is “nothing”, well what does that say about the quality of the PE firm’s due diligence and deal-making prowess? How can you go public with an offer that values Ambow at $105 million and only eleven days later have to abandon the bid because of chaos, and perhaps fraud, inside the target company?

It is so easy, so attractive,  to think you can do deals based largely on work you can do on a Bloomberg terminal. Just four steps are all that’s needed. Download the stock chart? Check. Read the latest SEC filings, including financial statements? Check. Discover a share trading at a fraction of book value? Check. Contact the company owner and say you want to become his partner and buy out all his foolish and know-nothing US shareholders? Check. All set. You can now launch your bid.

Here the stock chart for Ambow since it went public on the NYSE:

 

 

So, in a little more than two years, Ambow’s market cap has fallen by 92%, from a high of over $1 billion, to the current level of less than $90mn. That’s not a lot higher than the company’s announced 2011 EBITDA of $54mn, and about equal to the total cash Ambow claimed, in its most recent annual report filed with the SEC, it had in the bank. Now really, who wouldn’t want to buy a company trading at 1.5X trailing EBITDA and 1X cash?

Well, start with the fact that it now looks like those numbers might not be everything they purport to be. That would be the logical inference from the fact that the company’s auditors and three of its board members all resigned en masse.

That gets to the heart of the real problem with these “PtP” (public to private) deals involving US-listed Chinese companies. The PE firms seem to operate on the assumption that the numbers reported to the SEC are genuine, and therefore that these companies’ shares are all trading at huge discounts to their intrinsic worth. Well, maybe not. Also, maybe US shareholders are not quite as dumb as some of the deal-makers here would like to believe. From the little we know about the situation in Ambow, it looks like, if anything, the US capital market was actually being too generous towards the company, even as it marked down the share price by over 90%.

A share price represents the considered assessment of millions of people, in real time. Some of those people (suppliers, competitors, friends of the auditor) will always know more than you about what the real situation is inside a company. Yes, sometimes share prices can overshoot and render too harsh a judgment on a company’s value. But, that’s assuming the numbers reported to the SEC are all kosher.  If we’ve learned anything in these last two years it’s that assuming a Chinese company’s SEC financial statement is free of fraud and gross inaccuracy is, at best, a gamble. There simply is no way a PE firm can get complete comfort, before committing to taking over one of these Chinese businesses listed in the US, that there are no serious dangers lurking within. Reputation risk, litigation risk, exit risk — these too are very prominent in all PtP deals.

Some of the other announced PtP deals are using borrowed money, along with some cash from PE firms, to pay off existing shareholders. In such cases, the risk for the PE fund is obviously lower. If the Chinese company genuinely has the free cash to service the debt, well, then once the debt is paid off, the PE firm will end up owning a big chunk of a company without having tied up a lot of cash.  Do the banks in these cases really know the situation inside these often-opaque Chinese companies? Is the cash flow on the P&L the same cash flow that passes through its hands each month?

There’s much else that strikes me as questionable about the logic of doing these PtP, or delist-relist deals. For one thing, it seems increasingly unlikely that these businesses will be able to relist, anytime in the next three to five years, in Hong Kong or China. I’ve yet to hear a credible plan from the PE firms I’ve talked to about how they intend to achieve ultimate exit. But, mainly, my concerns have been about the rigor and care that goes into the crafting of these deals. Those concerns seem warranted in my opinion, based on this 11-day debacle with Baring and Ambow.

Some of the Chinese-listed companies fell out of favor for the good reason that they are dubious businesses, run with shoddy and opaque practices, by bosses who’ve shown scant regard for the letter and spirit of the securities laws of the US. Are these really the kind of people PE funds should consider going into business with?

 

Correction: I see now Barings actually has owned some Ambow shares for longer, and so is likely sitting on far larger losses on this position. This raises still more starkly the issue of how it could have put so much of its LPs money at risk on a deal like this, upfront, and without having sufficient transparency into the true situation at the company. This looks more like stock speculation gone terribly wrong, not private equity.

Addition: Three other large, famous institutional investors also all piled into Ambow in the months before Baring made its bid. Fidelity, GIC and Capital Group reported owning 8.76%, 5.2% and 7.4% respectively, or a total of 21.3% of the equity. They might have made a quick buck had the Baring buyout gone forward. Now, they may end up stranded, sitting on large positions in a distressed stock with no real liquidity and perhaps nowhere to go but down.

 

 

Out of Focus: China’s First Big LBO Deal is a Headscratcher

The first rule of capitalism is the more buyers you attract, the higher the price you get. So, having just one potential buyer is generally a lousy idea when your goal is to make as much money as possible.

What then to make of the recently-announced plan by an all-star team of some of China’s largest PE firms, including CDH, Fountainvest, CITIC Capital, as well global giant Carlyle,  to participate in a $3.5 billion proposed leveraged buyout deal to take private the NASDAQ-listed Chinese advertising company Focus Media. Any profit from this “take private” deal, as far as I can tell,  hinges on later flipping Focus Media to a larger company. That’s because the chances seem slight a privatized Focus Media will be later approved for domestic Chinese IPO. But, what if Focus turns out to be flip-proof?

With so much money — as so many big name PE firms’ reputations —  on the line, you’d think there would a clear, persuasive investment case for this Focus Media deal. As far as I can tell, there isn’t. I have the highest respect for the PE firms involved in this deal, for their financial and investing acumen. They are the smartest and most experienced group of PE professionals ever assembled to do a single Chinese deal. And yet, for the life of me, I can’t figure out what they are thinking with this deal and why they all want a piece of this action.

If the goal is to try to arbitrage valuation differences between the US and Chinese stock markets, this deal isn’t likely to pan out. It’s not only that Focus Media will have a tough time convincing China’s securities regulator, the CSRC, to allow it to relist in China. Focus Media is now trading on the NASDAQ at a trailing p/e multiple of 18. That is on the high side for companies quoted in China.

Next problem, of course, is the impact on the P&L from all the borrowing needed to complete the deal. There’s been no clear statement yet about how much equity the PE firms will commit, and how much they intend to borrow. To complete the buyout, the investor group, including the PE firms along will need to buy about 65% of the Focus equity. The other 35% is owned by Focus Media’s chairman and China’s large private conglomerate Fosun Group. They both back the LBO deal.

So, the total check size to buy out all other public shareholders will be around $2.4 billion, assuming they investor group doesn’t need to up its offer. If half is borrowed money, the interest expense would swallow up around 50% Focus Media’s likely 2012 net income. In other words, the LBO itself is going to take a huge chunk out of Focus Media’s net income.  In other words, the PE group is actually paying about twice the current p/e to take Focus Media private, since its purchase mechanism will likely halve profits.

A typical LBO in the US relies on borrowed money to finance more than half the total acquisition cost. The more Focus Media borrows, the bigger the hit to its net income. Now, sure, the investors can argue Focus Media should later be valued not on net income, but on EBITDA. That’s the way LBO deals tend to get valued in the US. EBITDA, though,  is still something of an unknown classifier in China. There isn’t even a proper, simple Chinese translation for it. Separately, Focus Media is already carrying quite a bit of debt, equal to about 60% of revenues. Adding another big chunk to finance the buyout, at the very least,  will create a very wobbly balance sheet. At worst, it will put real pressure on Focus Media’s operating business to generate lots of additional cash to stay current on all that borrowing.

I have no particular insight into Focus Media’s business model, other than to note that the company is doing pretty well while already facing intensified competition. Focus Media doesn’t meet the usual criteria for a successful LBO deal, since it isn’t a business that seems to need any major restructuring, refocusing or realignment of interests between owners and management.

Focus Media gets much of its revenue and profit from installing and selling ads that appear on LCD flatscreens it hangs in places like elevators and retail stores. It’s a business tailor-made for Chinese conditions. You won’t find an advertising company quite like it in the US or Europe. In a crowded country, in crowded urban shops, housing blocks and office buildings, you can get an ad in front of a goodly number of people in China while they are riding up in a jammed elevator or waiting at a checkout counter.

The overall fundamentals with Focus Media’s business are sound. The advertising industry in China is growing. But, it’s hard to see anything on the horizon that will lift its current decent operating performance to another level. Without that, it gets much harder to justify this deal.

This is, it should be noted, the first big LBO ever attempted by a Chinese company. It could be that the PE firms involved want to get some knowledge and experience in this realm, assuming that there could be more Chinese LBOs coming down the pike. Maybe. But, it looks like it could be pretty expensive tuition.

Assuming they can pull off the “delist” part of the deal, the PE firms will need to find a way to exit from this investment sometime in the next three to five years. Focus Media’s chairman has been vocal in complaining about the low valuation US investors are giving his company. In other words, he believes the company’s shares can be sold to someone else, at some future date, at a far higher price. (He personally owns 17% of the equity.)

Who exactly, though, is this “someone else”? Relisting Focus Media in China is a real long shot, and anyway, the current multiples, on a trailing basis, are comparable with NASDAQ’s . This is before calculating the hit Focus Media’s earnings will take from leveraging up the company with lots of new debt. How about the Hong Kong Stock Exchange? Focus Media would likely be given a warm welcome to relist there. One problem: with Hong Kong p/e multiples limping along at some of the lowest levels in the world, the relisted Focus Media’s market value would almost certainly be lower than the current price in the US. Throw in, of course, millions of dollars in legal fees on both sides of the delist-relist, and this Hong Kong IPO plan looks like a very elaborate way to park then lose money.

That leaves M&A as the only viable option for the PE investor group to make some money. I’m guessing this is what they have on their minds, to flip Focus Media to a larger Chinese acquirer.  They may have already spoken to potential acquirers, maybe even talked price. The two most obvious acquirers, Tencent Holdings and Baidu, both may be interested. Baidu has done some M&A lately, including the purchase, at what looks to many to be a ridiculously high price, of a majority of Chinese online travel site Qunar.  So far so good.

The risk is that neither of these two giants will agree to pay a big price down the line for a company that could buy now for much less. The same logic applies to any other Chinese acquirer, though they are few and far between. I’d be surprised if Tencent or Baidu haven’t already run the numbers, maybe at Focus Media’s invitation. But, they didn’t make a move. Not up to now.

Could it be they don’t want to do the buyout directly, out of fear it could go wrong or hurt their PR? Maybe. But, I very much doubt they will be very eager to play the final owner in a very public “greater fool” deal.

I’m fully expecting to be proven wrong eventually by this powerhouse group of PEs, and that they will end up dividing a huge profit pile from this Focus Media LBO. If so, the last laugh is on me. But,  as of now, the Focus deal’s investment logic seems cockeyed.

 

 

Cease and Desist on Delist-Relist — Wall Street Journal Op-Ed

WSJ1

It’s only a moderate exaggeration to say that everything I’ve learned of value and enduring truth about politics and economics over the last 25 years came from the editorial pages of the Wall Street Journal. For just as long, the one writing goal I’ve held onto was having an op-ed published there. Today’s the day.

Cease and Desist on Delist-Relist” is running in today’s Asian edition. I’m delighted. I owe a huge debt of thanks to the Journal’s Joe Sternberg who encouraged me to submit the piece, and then did masterful work shaping and reworking the text from earlier blog posts. 

I’ve known my fair share of editors. When I was at Forbes Magazine many years ago, I had the good fortune to have a fair percentage of my stories edited directly the then Editor-in-Chief, Jim Michaels, who richly deserves the reputation as one of the finest ever in business journalism. He was a maestro. Other Forbes editors? Often klutzes. Joe’s editing work is of Michaels quality. I have no higher standard, or stouter praise.

The full text as published by the Journal is copied below. For anyone who’d like to read the earlier draft, about 15% longer than this version, you can click here. 

  
  
 

 

  • The Wall Street Journal

 

Foreign private-equity firms have a history of running into trouble in China. Generally consigned to buying minority stakes instead of the traditional buy-out-and-turn-around model they mastered back home, several big-name firms have become collateral damage in various corporate fraud sagas. Yet now some PE investors look set to jump into what could be the worst China investment move of all: the “delist-relist” deal.

The theory is simple. Hundreds of Chinese companies have gained listings in the U.S. via reverse takeovers, injecting all of their assets into a dormant shell company with shares traded on NASDAQ, AMEX or, more commonly, over-the-counter. Only then do the Chinese firms discover the enormous compliance costs associated with being listed in America, not to mention the low valuations for U.S.-traded shares relative to what a Chinese company could pull from equity markets back in China.

Enter PE investors to buy out the American shareholders, delist in the U.S., and then cash out by relisting in China. Several such deals have already been hatched, including one by Bain Capital to spend $100 million taking private NASDAQ-listed China Fire & Security Group; two deals orchestrated by Hong Kong-based Abax Capital, the planned buyouts of NASDAQ-listed Harbin Electric and Fushi Copperweld for more than $700 million; and Fortress Group’s financing to take Funtalk Holdings’ private. Conversations with market participants suggest quite a few other PE firms are now actively looking at such transactions.

Yet while the superficial appeal is clear, the risks are enormous and unmanageable, and have the potential to mortally wound any PE firm that tries.

The first problem relates to the aspect that most excites PE firms about delist-relist deals: the low share price in the U.S. The assumption generally is that this is simply bad luck. Many Chinese companies ended up trading over-the-counter or at low valuations on NASDAQ as a result of their reverse mergers. Share prices stay depressed, the theory goes, because American investors don’t understand the company’s business or trust its accounting.

That may be too generous to the Chinese executives. Those managers were foolish to have done a reverse merger in the first place. One can infer the boss has little knowledge of capital markets and took few sensible precautions before pulling the trigger on the backdoor listing that has probably cost the firm at least $1 million in fees to complete and ongoing regulatory compliance. An “undervalued asset” in the control of someone misguided enough to go public this way may not be undervalued after all.

Next, there are the complexities of taking a company private. For instance, class-action lawsuits have become fairly common in any kind of merger or acquisition deal in the U.S., with minority shareholders often disputing the valuation. With Chinese companies, distance, differences in accounting rules, and unusual corporate structures are likely to lead to bigger disputes over what a company is actually worth.

As if all that weren’t bad enough, it is far from certain that these Chinese companies, once taken private, will be able to relist in China. Any proposed initial offering in China must gain the approval of the China Securities Regulatory Commission. There is a low chance of success. No one knows the exact numbers, but from my own conversations with Chinese regulators, it seems likely that only 10%-15% of the more than 150 companies per month that applied to list last year gained listings. Companies whose U.S. listings failed will almost certainly suffer a serious stigma in the CSRC’s eyes. PE firms could end up owning firms that are delisted in the U.S. and unlistable in China.

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its limited partners for breach of fiduciary duty. Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to raise money. In other words, PE firms that do delist-relist deals may be taking an existential risk.

Why, then, are PE firms considering these deals? Because they appear easy. The target company is usually already trading on the U.S. stock market, and so has a lot of disclosure materials available. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog requiring extensive due diligence. Delist-relist seems like an easy way in, especially for smaller, less experienced PE firms.

By some counts, America’s largest export to China is now trash and scrap for recycling. These delist-relist deals have a similar underlying logic, that PE firms can turn American muck into brass in China. But that’s a big and very dangerous gamble. The only people certain to do well out of these deals are U.S. investors who sell out now at a small premium in the “take private” part of the deal.

Mr. Fuhrman is chairman and chief executive of China First Capital. This column is adapted from a report recently published by CFC.

Download PDF version.

 

 

Crawling Blindfold & Naked Through A Minefield

 

Making a failed investment is usually permissible in the PE industry. Making a negligent investment is not. The PE firms now considering the “delist-relist” transactions I wrote about last time (click here to read)  are jeopardizing not only their investors’ money, but the firm’s own survival.  The risks in these deals are both so large and so uncontrollable that if a deal were to go wrong, the PE firm would be vulnerable to a lawsuit by its Limited Partners (“LPs”) for breach of fiduciary duty.

Such a lawsuit, or even the credible threat of one, would likely put the PE firm out of business by making it impossible for the firm to ever raise money from LPs again. In other words, PE firms that do “delist-relist” are taking existential risk. To this old guy, that is just plain dumb.

Before making any investment, a PE firm, to fulfill its fiduciary duty, will do extensive, often forensic, due diligence. The DD acts as a kind of inoculation, protecting the PE firm in the event something later goes wrong with the investment. As long as the DD was done properly, meaning no obvious risks were ignored, then a PE firm can’t easily be attacked in court for investing in a failed deal.

With the “delist-relist” deals however, there is no way for the DD process to fully determine the scale of the largest risks, nor can the PE firm do much to hedge, manage or alleviate them. This is because the largest risks are inherent in the deal structure.

The two main ones are the risk of shareholder lawsuits and the risk that the company, after being taken private, will fail to win approval for an IPO on a different stock market. If either occur, they will drain away any potential profit. Both risks are fully outside the control of the PE firm. This makes these deals a blindfolded and naked crawl through a minefield.

Why, then, are PE firms considering these deals? From my discussions, one reason is that they appear easy. The target company is usually already trading on the US stock market, and so has a lot of SEC disclosure materials available. All one needs to do is download the documents from the SEC’s Edgar website. Investing in private Chinese companies, by contrast, is almost always a long, arduous and costly slog – it involves getting materials, like an audit, and then making sure everything else provided by the company is genuine and accurate.

Another reason is ignorance of or indifference to the legal risks: many of the PE firms I’ve talked to that are considering these “delist-relist” deals have little direct experience operating in the US capital markets. Instead, the firm’s focus on what they perceive to be the “undervaluation” of the Chinese companies quoted in the US. One PE guy I know described the Chinese companies as “miss-killed”, meaning they are, to his way of thinking, basically solid businesses that are being unfairly scorned by US investors. There may well be some good ones foundering on US stock markets. But, finding them and putting the many pieces together of a highly-complex “delist-relist” deal is outside the circle of competence and experience of most PE firms active in China.

This investment approach, of looking for mispriced or distressed assets on the stock market,  is a strategy following by many portfolio managers, distress investors and hedge funds. PE firms operating in China, however, are a different breed, and raised money from their LPs, in most cases, by promising to do different sorts of deals, with longer time horizons and a focus on outstanding private companies short of growth capital. The PE firm acts as supportive rich uncle, not as a crisis counselor.

Abandoning that focus on strong private companies, to pursue these highly risky “delist-relist” deals seems not only misguided, but potentially reckless. Virtually every working day, private Chinese companies go public and earn their PE investors returns of 400% or more. There is no shortage of great private companies looking for PE in China. Just the opposite. Finding them takes more work than compiling a spreadsheet with the p/e multiples of Chinese companies traded in the US.  But, in most cases, the hard work of finding and investing in private companies is what LPs agreed to fund, and where the best risk-adjusted profits are to be made.  How will LPs respond if a PE firm does a “delist-relist” deal and then it goes sour? This, too, is a suicidal risk the PE firm is taking.