Reverse merger stocks hardest hit
Analysts eye arbitrage opportunities
More Chinese companies listed in the US are considering going private as scandals dogging the sector harm their valuations, according to investment bankers working with those companies.
Chinese companies listed overseas, mainly in the US and Hong Kong, have suffered increasing numbers of fraud allegations this year, as the developing industry of funds that publish negative research on these stocks while shorting them finds more and more targets.
The hardest-hit stocks tend to be smaller companies that went public via the reverse-merger process, in which the Chinese company takes over an already-listed US public shell company.
“One company in my portfolio,” says a Shanghai-based fund manager, “is a great business trading at barely three times price/earnings. If it were a private company, I think its value in the portfolio would shoot up immensely – there’s a crisis of credibility attached to overseas-listed Chinese stocks that’s harming the majority of good, legitimate companies.”
Seven listed Chinese companies have made privatization announcements since the fourth quarter of 2010, according to research from BNP Paribas. That creates an investment opportunity in itself, says an analyst at the bank, Derrick Sun: “Since there are still uncertainties associated with the [privatization] process, most of them are still trading at deep discount of their offered price. The average upside to offer prices among the seven is 76.7%. We believe one successful privatization case will have a positive share price impact on the rest. These stocks outperformed the US listed group in the past 30 days.”
Industry sources say that hedge funds and private-equity firms are now scouring the universe of US-listed China stocks for companies that they can persuade to go private, with a view to relisting once the current wave of stock fraud accusations has passed and valuations return.
“I know a lot of investors looking at taking private opportunities,” says the fund manager in Shanghai, “but the problem is persuading the Chinese side. It’s a feather in the chief executive officer’s cap to be listed in America, and going private can look like an admission of defeat, especially if you made a big fanfare of the initial public offering.”
Limited options
Many small Chinese companies chose to go public in the US in the first place because their other options were limited. China’s banks tend to lend more freely to state-owned enterprises than to the private sector, and raising money in the domestic debt and equity markets is a slow process requiring many levels of approval from multiple regulators.
“Being an orphaned micro-cap stock in the US is bad,” says Sahm Adrangi of New York-based fund Kerrisdale Capital, “but many Chinese companies have no other choice.”
He offers a possible explanation in the case of any companies where fraud is proven: “For some of them, faced with [the choice of] continuing to report real numbers about which nobody cares or starting to inflate the figures a little...I think a lot of these companies had no intention of being scams, but became so when faced with the harsh reality of being a $50 million market cap stock with no equity coverage on a smaller exchange in the US.”
The business of taking Chinese companies public, and indeed of helping them go private again, can be lucrative but the negative publicity surrounding the sector at the moment is making fund managers and investment bankers increasingly nervous. Euromoney has seen an email circulated by the Asia head of a global investment bank to his entire China team, urging them to be cautious in dealing with small and mid-sized companies and reminding them to keep full records of their due diligence in light of the recent scandals.
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