Morgan Stanley

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.

 

Smithfield Foods – Shuanghui International: The Biggest Chinese Acquisition That Isn’t


It is, if voluminous press reports are to be believed, the biggest story, the biggest deal, ever in China-US business history. I’m talking about the announced takeover of America’s largest pork company, Smithfield Foods, by a company called Shuanghui International. The deal, it is said in dozens of media reports, opens the China market to US pork and will transform China’s largest pork producer into a global giant selling Smithfield’s products alongside its own in China, while utilizing the American company’s more advanced methods for pork rearing and slaughtering.

One problem. A Chinese company isn’t buying Smithfield. A shell company based in Cayman Islands is. Instead of a story about “China buying up the world”, this turns out to be a story of a precarious leveraged buyout deal (“LBO”) cooked up by some large global private equity firms looking to borrow their way to a fortune.

The media, along with misstating the facts, are also missing the larger story here. The proposed Smithfield takeover is the latest iteration in the “take private” mania now seizing so many of the PE firms active in China. (See blog posts hereherehere and here.) With China’s own capital markets in crisis and PE investment there at a standstill, the PE firms have turned their attention, however illogically, to finding “undervalued assets” with a China angle on the US stock market. They then attempt an LBO, with the consent of existing management, and with the questionable premise the company will relist or be sold later in China or Hong Kong. The Smithfield deal is the biggest — and perhaps also the riskiest —  one so far.

This shell that is buying Smithfield has no legal or operational connection to Henan Shuanghui Investment & Development (from here on, “Shuanghui China”) , the Chinese pork producer, China’s largest, quoted on the Shenzhen stock exchange. The shell is about as Chinese as I am.

If the deal is completed, Shuanghui China will see no obvious benefit, only an enormous risk. Its Chinese assets are reportedly being used as collateral for the shell company to finance a very highly-leveraged acquisition. The abundant risks are being transferred to Shuanghui China while all the profits will stay inside this separately-owned offshore shell. No profits or assets of Smithfield will flow through to Shuanghui China. Do Shuanghui China’s Chinese minority shareholders know what’s going on here? Does the world’s business media?

Let’s go through this deal. I warn you. It’s a little convoluted. But, do take the time to follow what’s going on here. It’s fascinating, ingenious and maybe also a little nefarious.

First, the buyer of Smithfield is Shuanghui International, a Cayman holding company. It owns the majority of Shuanghui China, the Chinese-quoted pork company. Shuanghui International is owned by a group led by China-focused global PE firm CDH, with smaller stakes owned by Shuanghui China’s senior management,  Goldman Sachs, Singapore’s Temasek Holdings, Kerry Group, and another powerful PE firm focused on China, New Horizon Fund.

CDH, the largest single owner of Shuanghui International,  is definitively not Chinese. It invests capital from groups like Abu Dhabi’s sovereign wealth fund , CALPERS, the Rockefeller Foundation, one big Swiss (Partners Group) and one big Liechtenstein (LGT) money manager, along with the private foundation of one of guys who made billions from working at eBay. So too Goldman Sachs, of course, Temasek and New Horizon. They are large PE firms that source most of their capital from institutions, pension fund and endowments in the US, Europe, Southeast Asia and Middle East. (For partial list of CDH and New Horizon Fund Limited Partners click here. )

For the Smithfield acquisition, Shuanghui International (CDH and the others) seem to be putting up about $100mn in new equity. They will also borrow a staggering $4 billion from Bank of China’s international arm to buy out all of Smithfield’s current shareholders.  All the money is in dollars, not Renminbi.

If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But, nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part-owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.

Shuanghui International, assuming it’s borrowed the money from Bank of China for three years,  will need to come up with about $1.5 billion in interest and principal payments a year if the deal closes. But, since Shuanghui International has no significant cash flow of its own (it’s an investment holding company), it’s hard to see where that money will come from. Smithfield can’t be much help. It already has a substantial amount of debt on its balance sheet. As part of the takeover plan, the Smithfield debt is being assumed by Morgan Stanley, Shuanghui International’s investment bankers. Morgan Stanley says it plans then to securitize the debt. A large chunk of Smithfield’s future free cash flow ($280mn last year) and cash ($139 mn as of the first quarter of 2013) will likely go to repay the $3 billion in Smithfield debts owed to Morgan Stanley.

A separate issue is whether, under any circumstances, more US pork will be allowed into China. The pork market is very heavily controlled and regulated. There is no likely scenario where US pork comes flooding into China. Yes, the media is right to say Chinese are getting richer and so want to eat more meat, most of all pork. But, mainly, the domestic market in China is reserved for Chinese hog-breeders. It’s an iron staple of China’s rural economy. These peasants are not going to be thrown under the bus so Smithfield’s new Cayman Islands owner can sell Shuanghui China lots of Armour bacon.

Total borrowing for this deal is around $7 billion, double Smithfield’s current market cap. Shuanghui International’s piece, the $4 billion borrowed from Bank of China, will go to current Smithfield shareholders to buy them out at a 31% premium.  Shuanghui International owns shares in Shuanghui China, and two of its board members are Shuanghui China top executives, but not much else. So where will the money come from to pay off the Bank of China loans? Good question.

Can Shuanghui International commandeer Shuanghui China’s profits to repay the debt? In theory, perhaps. But,  it’s highly unlikely such an arrangement would be approved by China’s securities regulator, the CSRC. It would not likely accept a plan where Shuanghui China’s profits would be exported to pay off debts owed by a completely independent non-Chinese company. Shuanghui International could sell its shares in Shuanghui China to pay back the debt. But, doing so would likely mean Shuanghui International loses majority control, as well as flooding the Shenzhen stock market with a lot of Shuanghui China’s thinly-traded shares.

Why, you ask, doesn’t Shuanghui China buy Smithfield? Such a deal would make more obvious commercial and financial sense. Shuanghui China’s market cap is triple Smithfield’s. Problem is, as a domestic Chinese company listed on China’s stock exchange, Shuanghui China would need to run the gauntlet of CSRC, Ministry of Commerce and SAFE approvals. That would possibly take years and run a risk of being turned down.  Shuanghui International, as a private Caymans company controlled by global PE firms,  requires no Chinese approvals to take over a US pork company.

The US media is fixated on whether the proposed deal will get the US government’s go ahead. But, as the new potential owner is not Chinese after all — neither its headquarters nor its ownership — then on what grounds could the US government object? The only thing Chinese-controlled about Shuanghui International is that the members of the Board of Directors were all likely born in China. The current deal may perhaps violate business logic but it doesn’t violate US national security.

So, how will things look if Shuanghui International’s LBO offer is successful?  Shuanghui China will still be a purely-Chinese pork producer with zero ownership in Smithfield, but with its assets perhaps pledged to secure the takeover debts of its majority shareholder. All the stuff about Shuanghui China getting access to Smithfield pork or pig-rearing and slaughtering technology, as well as a Smithfield-led upgrade of China’s pork industry,  is based on nothing solid. The pork and the technology will be owned by Shuanghui China’s non-Chinese majority shareholder. It can, if it chooses, sell pork or technology to Shuanghui China. But, Shuanghui China can achieve the same thing now. In fact, it is already a reasonably big buyer of Smithfield pork. Overall, China gets less than 1% of its pork from the US.

If the deal goes through, the conflicts of interest between Shuanghui International and Shuanghui China will be among the most fiendish I’ve ever seen. Shuanghui China’s senior managers, including chairman Wan Long, are going to own personally a piece of Smithfield, and so will have divided loyalties. They will likely continue to manage Shuanghui China and collect salaries there, while also having an ownership and perhaps a management role in Smithfield. How will they set prices between the two fully separate Shuanghuis? Who will watch all this? Isn’t this a case Shuanghui China’s insiders lining their own pockets while their employer gets nothing?

On its face, this Smithfield deal looks to be among the riskiest of all the  “take private” deals now underway. That is saying something since several of them involve Chinese companies suspected of accounting frauds, while the PE firms in at least two cases (China Transinfo and Le Gaga) doing the PE version of a Ponzi Scheme by seeking to use new LP money to bail out old, severely troubled deals they’ve done.

Let’s then look at the endgame, if the Smithfield deal goes through. Shuanghui International, as currently structured,  will not, cannot, be the long-term owner of Smithfield. The PE firms will need to exit. CDH, New Horizon, Goldman Sachs and Temasek have been an indirect shareholders of Shuanghui China for many years — seven in the case of CDH and Goldman.

According to what I’m told, Shuanghui International is planning to relist Smithfield in Hong Kong in “two to three years”. The other option on the table, for Shuanghui International to sell Smithfield (presumably at a mark-up) to Shuanghui China, would face enormous, probably insurmountable,  legal, financial and regulatory hurdles.

The IPO plan, as of now, looks crackpot. Hong Kong’s IPO market has basically been moribund for over a year. IPO valuations in Hong Kong are anyway far lower than the 20X p/e Shuanghui International is paying for Smithfield in the US. A separate tactical question for Shuanghui International and its investment bankers: why would you believe Hong Kong stock market investors in two to three years will pay more than US investors are now paying for a US company, with most of its assets, profits and revenues in the US?

But, even getting to IPO will require Shuanghui International to do something constructive about paying off the enormous $4 billion in debt it is taking on. How will that happen? Shuanghui International is saying Smithfield’s current American management will stay on. Why would one assume they can run it far more profitably in the future than they are running it now? If it all hinges on “encouraging” Shuanghui China to buy more Smithfield products, or pay big licensing fees, so Shuanghui International can earn larger profits, I do wonder how that will be perceived by both Shuanghui China’s minority investors, to say nothing of the CSRC. The CSRC has a deep institutional dislike of related party transactions.

Smithfield has lately been under pressure from some of its shareholders to improve its performance. That may have precipitated the discussions that led to the merger announcement with Shuanghui International. Smithfield’s CEO, C. Larry Pope, stands to earn somewhere between $17mn-$32mn if the deal goes through. He will stay on as CEO. His fiscal 2012 salary, including share and option awards, was $12.9mn.

Typical of such LBO deals, the equity holders (in this case, CDH, Goldman, Temasek, Kerry Group, Shuanghui China senior management, New Horizon) would stand to make a killing, if they can pay down the debt and then find a way to either sell or relist Smithfield at a mark-up. If that happens, profits will go to the Shuanghui insiders along with the partners in the PE firms, CALPERS, the Rockefeller and Carnegie foundations, Goldman Sachs shareholders and other LPs. Shuanghui China? Nothing, as far as I can tell. China’s pork business will look pretty much exactly as it does today.

In their zeal to proclaim a trend — that of Chinese buying US companies — the media seems to have been blinded to the actual mechanics of this deal. They also seem to have been hoodwinked by the artfully-written press release issued when the deal was announced. It mentions that Shuanghui International is the ” majority shareholder of Henan Shuanghui Investment & Development Co. (SZSE: 000895), which is China’s largest meat processing enterprise and China’s largest publicly traded meat products company as measured by market capitalization.” This then morphed into a story about “China’s biggest ever US takeover”, and much else besides about how China’s pork industry will now be upgraded through this deal, about dead pigs floating in the river in Shanghai, about Chinese companies’ targeting US and European brands.

China may indeed one day become a big buyer of US companies. But, that isn’t what’s happening here. Instead, the world’s leading English-language business media are suffering a collective hallucination.

Smithfield & Shuanghui: One little piggy comes to market — Week In China

week in china

A record bid for America’s top pork producer isn’t quite as it first appears

“What I do is kill pigs and sell meat,” Wan Long, chairman at Henan Shuanghui Development, told Century Weekly last year.

It’s an admirably succinct job description for a man who has been lauded by China National Radio as the “Steve Jobs of Chinese butchery” (Jobs, a vegan, probably wouldn’t have approved).

Starting out with a single processing factory in Luohe in Henan province, Shuanghui is now the largest meat producer in China, having benefitted in recent years from a shift in the Chinese diet away from rice and vegetables towards more protein.

So the announcement that it is now making a bid for the world’s largest hog producer, Smithfield Foods from Virginia in the US, prompted a flurry of headlines about the significance of the deal; its chances of getting security clearance from the Committee on Foreign Investment in the United States (CFIUS); and the broader implications for the meat trade in both countries if the takeover goes through.

Yet although Wan makes his profession sound like a simple one, Shuanghui’s bid for Smithfield turns out to be rather more complicated than many first assumed. Far from a case of a Chinese firm swooping in on an American target, the takeover reflects more complex trends too, including some of the peculiarities of the Chinese capital markets.

What first made headlines on the deal?

Privately-owned Shuanghui International has bid $7.1 billion for Smithfield Foods (including taking on its debt) in what the media is widely presenting as the biggest acquisition yet by a Chinese company of a US firm.

Shuanghui has processing plants in 13 provinces in China and produces more than 2.7 million tonnes of meat each year. But the plan is now to add Smithfield’s resources to the mix. “The acquisition provides Smithfield the opportunity to expand its offering of products to China through Shuanghui’s distribution network,” Wan announced. “Shuanghui will gain access to high-quality, competitively-priced and safe US products, as well as Smithfield’s best practices and operational expertise.”

What’s behind the move?

Most analysts have chosen to focus on Shuanghui’s desire to secure a more consistent supply of meat. Currently, it raises 400,000 of its own hogs a year, only a small share of the 11 million that it needs. That makes it reliant on other breeders in a country where the latest scare about contaminated meat is never far from the headlines. In the most recent case in March, the carcasses of thousands of pigs suddenly started floating down the Huangpu river upstream of Shanghai, after an outbreak of disease in nearby farms and a clampdown on the illicit sale of infected meat (see WiC186).

Now Shuanghui is said to be looking further afield to secure meat, and from a source that would allow it to differentiate its product range from that of its competitors.

“They’re a major processor who wants to source consistent, large volumes of raw material. You want to look at the cheapest sources and in the US, we’re very competitive,” Joel Haggard from the US Meat Export Federation told Bloomberg. Average hog prices in China are currently about $2.08 per kilo or a third higher than in the United States, Haggard also suggested.

How about changes in the industry in China?

A second theory is that Shuanghui is developing a more integrated supply chain in China and wants Smithfield’s help to complete the process.

This was something that C Larry Pope, chief executive at Smithfield, cited as a key factor in its willingness to pay a 31% premium for Smithfield stock. If so, that’s something of an irony: Continental Grain, Smithfield’s largest investor, has been pushing for a break up of the business to unlock more value for investors.

Still, an argument can be made that industry conditions are different in China, where the supply chain is shifting away from its reliance on more traditional household farming (the Mandarin character for “home” depicts a pig under a roof, for instance) to one in which large-scale, industrialised production begins to dominate.

Food safety concerns and the need to improve quality standards are also driving change across the industry. Yet despite signs of consolidation in hog breeding and slaughtering, integration across the full supply chain is a challenge. Shuanghui has already been trying to develop more of its own cold chain rather than rely on third parties (it operates seven private railways to transport its goods to 15 logistics centres, for instance, and has also invested in hundreds of its own retail outlets). But the Smithfield acquisition could help further with the integration effort, especially in areas such as adopting technology that tracks meat from farm to fork.

Paul Mariani, a director at agribusiness firm Variant Capital Advisors, told the Wall Street Journal last week that these systems have huge food safety benefits, allowing producers to track meat back to “where it was grown”. By contrast, Chinese suppliers struggle to achieve the same level of control, especially for meat sourced from the large number of smaller, family-owned firms.

How about in the US? Are Americans pleased with the deal?

The bid has already been referred to CFIUS, the committee that reviews the national security implications of foreign investments in US firms. But Smithfield’s Pope sounds confident, saying that he doesn’t expect “any concern” from the regulatory committee.

“We’re not exporting tanks and guns and cyber security,” he told reporters. “These are pork chops.”

All the same, the regulators will look at Smithfield’s supply contracts with the military, as well as whether any of its farms and factories are close to sensitive locations, an issue that has led to transactions being blocked or amended in the past.

For instance, the Obama administration intervened in the purchase of four Oregon wind farms by a Chinese acquirer this year because they were too close to a naval base.

“There’s a difference between a foreign company buying Boeing and one buying a hot dog stand,” Jonathan Gafni, president of Compass Point Analytics, which specialises in security reviews of this type, told the New York Times. “But it depends on which corner the stand is on.”

The committee will also look at whether Shuanghui could be in a position to disrupt the distribution of pork to American consumers. Indeed, Charles Grassley, the Republican Senator of Iowa, has already urged regulators to look closely at whether the Chinese government has any influence on Shuanghui’s management.

More ominously on Wednesday the chairwoman of the Senate’s Agriculture Committee expressed her concerns. Debbie Stabenow said those federal agencies considering the merger must take into account “China’s and Shuanghui’s troubling track record in food safety”. She further added that those agencies must “do everything in their power to ensure our national security and the health of our families is not jeopardised”.

Despite such concerns, the food security argument looks limited in scope, although some of the Chinese newspapers don’t expect the review to pass without issue. “Even the conspicuous absence of national security factors can hardly guarantee that US protectionists will not poke their noses into it,” the China Daily suggested pointedly.

Back in Washington, Elizabeth Holmes, a lawyer working for the Center for Food Safety, has also called for regulators to consider the bid from the wider perspective of food safety. “They’re supposed to identify and address any national security concerns that would arise,” she warned. “I can’t imagine how something like public health or environmental pollution couldn’t be potentially construed as a national security concern.”

The implication is that the takeover might damage Smithfield’s operations in the United States in some way, even leading to contamination among its locally sold products. Hence the fact that Shuanghui was forced to recall meat tainted by the additive clenbuterol two years ago has been seized upon by the deal’s critics.

Again, the Chinese media response has tended to be indignant, with widespread reference to Smithfield’s own use of ractopamine, an additive similar to clenbuterol that’s banned in hog rearing in China but not by authorities in the US.

According to Reuters, Smithfield has been trying to phase out its usage of the drug, presumably to clear the way for an increase in sales to China. And in response to American anxiety about food safety post-takeover at Smithfield, both parties have gone out of their way to reiterate that the goal is to export more American pork to the Chinese, and not vice versa. Smithfield’s chief executive Pope has argued the case directly, citing the superiority of American meat. “People have this belief…that everything in America is made in China,” he told reporters. “Open your refrigerator door, look inside. Nothing in there is made in China because American agriculture is the most competitive and efficient in the world.”

Similarly, Shuanghui executives are insisting that nothing will change in how Smithfield serves up its sausages to American customers. The company will continue to be run on a standalone basis under its current management team, no facilities will be closed, no staff will be made redundant and no contracts will be renegotiated. Food safety standards will remain as today. “We want the business to stay the same, but better,” Wan said.

So it sounds like the Smithfield deal could turn out to be a major coup for the Chinese buyer?

Not really, says Peter Fuhrman, chairman of China First Capital, a boutique investment bank and advisory firm based in Shenzhen. He thinks that much of the analysis of the bid for Smithfield has completely missed the point. That’s because Shuanghui International – the entity making the offer – is a shell company based in the Cayman Islands. It isn’t a Chinese firm at all, he says.

Shuanghui International also has majority control of Shuanghui Development, the Shenzhen-listed firm that runs the domestic meat business in China. But it is controlled itself by a group of investors led by the private equity firm CDH (based in China but heavily backed by Western money) and also featuring Goldman Sachs, Temasek Holdings from Singapore and Kerry Group.

The management at Shuanghui, led by Wan, holds a small stake in the new, offshore entity. But as far as Fuhrman is concerned, Shuanghui International has no legal or operational connection to Shuanghui’s domestic operations.

“If the deal goes through, Smithfield Foods and Shuanghui China will have a majority shareholder in common. But nothing else. They are as related as, for example, Burger King and Neiman Marcus were when both were part owned by buyout firm TPG. The profits and assets of one have no connection to the profits or assets of the other.”

Of course, this raises questions about how the bid for Smithfield is being debated, especially its portrayal as the biggest takeover of a US firm by a Chinese one to date. It prompts queries too about the national security review underway in Washington, particularly any focus on the supposedly Chinese identity of the bidder. As it turns out, the Shuanghui bidding vehicle simply isn’t constituted in the way that people like Senators Grassley and Stabenow seem to believe.

So what is going on? Fuhrman says the bid for Smithfield is actually a leveraged buyout, made during a period in which private equity firms have been prevented from exiting their investments in China by blockages in the IPO pipeline (see WiC176 for a fuller discussion on this).

Instead, the investors that own Shuanghui are borrowing billions of dollars from the Bank of China and others to fund their purchase, with Fuhrman noting speculation that the plan is to relist Smithfield at a premium in Hong Kong in two or three years time.

How Shuanghui International is going to meet the interest payments on its borrowings in the meantime is less clear. But one possibility is that it will lean on Shuanghui Development, the operator in the Chinese market, to share some of the financial load. That could be problematic, raising hackles at the China Securities Regulatory Commission. It also prompts questions about the potential conflicts of interest (“among the most fiendish I’ve ever seen,” says Fuhrman) in the relationship between the investors that own Smithfield and the fuller group of shareholders at Shuanghai in China.

Ma Guangyuan, an economics blogger with more than half a million readers, takes a similar view. “If Shuanghui International acquires Smithfield Foods and sells the meat at high prices to Shuanghui Development, this will increase profits for the privatised Smithfield, but may not do much to help Shuanghui Development,” he predicts.

A further possibility is that having to service the LBO debt could curtail much of the investment envisaged by those who see the Smithfield purchase as a game-changing move for the industry. Of course, if it all goes to plan, the bid for Smithfield might turn out to be a game-changer for a small group of highly leveraged investors.But the jury must still be out on whether it will be quite so transformational for China’s domestic meat industry at large.

 

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The “OTCBB-ization” of the Hong Kong Stock Exchange

From the world’s leading IPO stock market to a grubby financial backwater with the sordid practices of America’s notorious OTCBB. Is this what’s to become of the Hong Kong Stock Exchange ?

I see some rather disturbing signs of this happening. Underwriters, with the pipeline of viable IPO deals drying up, are fanning out across China searching for mandates and making promises every bit as mendacious and self-serving as the rogues who steered so many Chinese companies to their doom on the US OTCBB.

The Hong Kong Stock Exchange (“HKSE”) may be going wrong because so much, until recently, was going right.  Thanks largely to a flood of IPO offerings by large Chinese companies, the HKSE overtook New York in 2009 to become the top capital market for new flotations. While the IPO markets turned sharply downward last year, and the amount of IPO capital raised in Hong Kong fell by half, the HKSE held onto the top spot in 2011. US IPO activity remains subdued, in part due to regulatory burdens and compliance costs heaped onto the IPO process in the US over the last decade.

During the boom years beginning around 2007, all underwriting firms bulked up by adding expensive staff in expensive Hong Kong. This includes global giants like Goldman Sachs, Citibank and Morgan Stanley, smaller Asian and European firms like DBS, Nomura, BNP Paribas and Deutsche Bank and the broking arms of giant Chinese financial firms CITIC, ICBC, CIIC, and Bank of China. The assumption among many market players was that the HKSE’s growth would continue to surge, thanks largely to Chinese listings, for years to come. With the US, Europe and Japan all in the economic and capital market doldrums, the investment banking flotilla came sailing into Hong Kong. Champagne corks popped. High-end Hong Kong property prices, already crazily out of synch with local buying power,  climbed still higher.

The underwriting business relies rather heavily on hype and boundless optimism to sell new securities. It’s little surprise, then, that IPO investment bankers should be prone to some irrational exuberance when it comes to evaluating their own career prospects. The grimmer reality was always starkly clear. For fundamental reasons visible to all but ignored by many, the flood of quality Chinese IPOs in Hong Kong was always certain to dry up. It has already begun to do so.

In 2006, the Chinese government closed the legal loophole that allowed many PRC companies to redomicile in Hong Kong, BVI or Cayman Islands. This, in turn, let them pursue IPOs outside China, principally in the US and Hong Kong. Every year, the number of PRC companies with this “offshore structure” and the scale and growth to qualify for an IPO in Hong Kong continues to decline. A domestic Chinese company cannot, in broad terms, have an IPO outside China.

Some clever lawyers came up with some legal fixes, including a legally-dubious structure called “Variable Interest Entity”, or VIE, to allow domestic Chinese companies to list abroad. But, last year, the Chinese Ministry of Commerce began moving to shut these down. The efficient, high-priced IPO machine for listing Chinese companies in Hong Kong is slowly, but surely, being starved of its fuel: good Chinese private companies, attractive to investors.

Yes, there still are non-Chinese companies like Italy’s Prada, Russia’s Rusal or Mongolia’s Erdenes Tavan Tolgoi still eager to list in Hong Kong. There is still a lot of capital, while listing and compliance costs are well below those in the US. But, the Hong Kong underwriting industry is staffed-up mainly to do Chinese IPOs. These guys don’t speak Russian or Mongolian.

So, the sorry situation today is that Hong Kong underwriters are overstuffed with overhead for a “coming boom” of Chinese IPOs that will almost certainly never arrive. China-focused Hong Kong investment bankers are beginning to show signs of growing desperation. Their jobs depend on winning mandates, as well as closing IPOs. To get business, the underwriters are resorting, at least in some cases, to behaviors that seem not that different from the corrupt world of OTCBB listing. This means making some patently false promises to Chinese companies about valuation levels they could achieve in an Hong Kong IPO.

The reality now is that valuation levels for most of the Chinese companies legally structured for IPO in Hong Kong are pathetically low. Valuations keep getting slashed to attract investors who still aren’t showing much interest. Underwriters are finding it hard to solicit buy offers for good Chinese companies at prices of six to eight times this year’s earnings. Some other deals now in the market and nowhere near close are being priced below four times this year’s net income. At those kind of prices, a HK IPO becomes some of the most expensive equity capital around.

In their pursuit of new mandates, however, these Hong Kong underwriters will rarely share this information with Chinese bosses. Instead, they bring with them handsomely-bound bilingual IPO prospectuses for past deals and suggest that valuation levels will go back into double digits in the second half of this year. In other words, the pitch is, “don’t look at today’s reality, focus instead at yesterday’s outcomes and my rosy forecast about tomorrow’s”.

This is the same script used by the advisors who peddled the OTCBB listings that damaged or destroyed so many Chinese companies over the last five years. Another similar tactic used both by OTCBB rogues and HK underwriters is to pray on fear. They suggest to Chinese bosses that they should protect their fortune by listing their company offshore, at whatever price possible and using whatever legally dubious method is available. They also play up the fact a Chinese company theoretically can go public in Hong Kong whenever it likes, rather than wait in an IPO queue of uncertain length and duration, as is true in China.

In other words, the discussion concerns just about everything of importance except the fact that valuation levels in Hong Kong are awful, and there is a decent probability a Chinese company’s HK IPO will fail. This is particularly the case for Chinese companies with less than USD$25 million in net income. The cost to a Chinese company of a failed IPO is a lot of wasted time, at least a million dollars in legal and accounting bills as well as a stained reputation.

There is, increasingly, a negative selection bias. Investors rightly wonder about the quality of Chinese companies, particularly smaller ones, being brought to market by underwriters in Hong Kong.

“No one has a crystal ball”, is how one Hong Kong underwriter, a managing director who spends most of his time in China scouring for mandates, explains the big gap between promises made to Chinese bosses, and the sad reality that many then encounter. In a real sense, this is on par with him saying “I’ve got to do whatever I’ve got to do to earn a living”. He can hold onto his job for now by bringing in new mandates, then hope markets will turn around at some point, the valuation tide will rise, and these boats will lift. This too is a business strategy used for many years by the OTCBB advisor crowd.

The OTCBB racket is now basically shut down. Those who profited from it are now looking for work or looking elsewhere for victims, er mandates. Tiny cleantech deals are apparently now hot.

My prediction is a similar retrenchment is on the way in Hong Kong, only this time those being retrenched won’t be fast-buck types from law firms and tiny OTCBB investment banks no one has heard of. Instead, it’ll be bankers with big salaries working at well-known brokerage companies. The pool of IPO fees isn’t big enough to feed them all now. And, that pool is likely going to evaporate further, as fewer Chinese companies sign on for Hong Kong listings and successfully close deals.