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

August 24th, 2011 1 comment

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.

 

 

China: The World’s Best Risk Adjusted Investment Opportunity

August 20th, 2011 1 comment

Seoul, Korea. At the Harvard Project for Asia and International Relations’ annual conference, I gave a talk today titled “China, The World’s Best Risk-Adjusted Investment Opportunity”. A copy of the PPT can be downloaded by clicking here. 

The slides are mainly just talking points, rather than fully fleshed-out contents. The idea was to work backwards from the conclusion, as propounded in the title, to the reasons why. My argument is that a confluence of factors are at work here, to create this agreeable situation where investing in Chinese private companies offers the highest returns relative to risk.

Those factors are:

  1. China’s current stage of six-pronged development (Slide 2)  
  2. A large group of talented entrepreneurs tested and tempered by the difficulties of starting and managing a private business in China (Slide 5)
  3. Plentiful equity capital (from private equity and venture capital firms) with clearly-articulated investment criteria (Slide 6)
  4. An investment strategy that offers multiple ways for capital to impact positively the performance of a private company,  lowering the already-minimal risk an investment will tank (Slide 7)
  5. The returns calculus (Slide 8 ) – the formula here is profits (in USD millions) multiplied by a p/e multiple, producing enterprise valuation. The first equation is an example of investor entry price, pre-IPO, and the second is investor exit price, after a round PE investment and an IPO. The gain is twenty-fold.  Thus do nickels turn into dollars
  6. Downsides – best risk-adjusted returns does not mean risk-free returns. Here are some of the ways that a pre-IPO investment can go bad (Slide 9

Since the audience in Seoul was largely non-Chinese, I also included two slides with the same map of China, illustrating the progression of economic development in China, from a few favored areas on China’s eastern seaboard during the early phases, to the current situation where economic growth, and entrepreneurial talent, is far more broadly-spread across the country.

As a proxy to illustrate this diffusion of economic dynamism across China, slide 4 shows, in gold, the areas of China where CFC has added clients and projects in the last 18 months. Slide 3 shows the original nucleus of economic success in China – Guangdong, Fujian, Zhejiang, Shanghai, Jiangsu and Beijing. We also have clients in these places. 

On seeing Slide 4, I realized it also displays my travel patterns over the last year.  I’ve been everywhere in red or gold, except Gansu, but adding in Yunnan, during that time. That’s a big bite out of a big country. This trip to Korea is my first flight outside China in two years, excepting a couple of short trips back to the US to see family. 

In the next two weeks, after returning from Korea, I’ll make three separate trips, to Henan, Jiangsu and Beijing, to visit existing clients and meet several potential new ones. While Chinese private SME provide the best risk-adjusted investment returns anywhere, you can’t do much from behind a desk. Opportunity is both widespread and widely-spread.

Private Equity in China, CFC’s New Research Report

August 14th, 2011 No comments

 

The private equity industry in China continues on its remarkable trajectory: faster, bigger, stronger, richer. CFC’s latest research report has just been published, titled “Private Equity in China 2011-2012: Positive Trends & Growing Challenges”. You can download a copy by clicking here.

The report looks at some of the larger forces shaping the industry, including the swift rise of Renminbi PE funds, the surging importance of M&A, and the emergence of a privileged group of PE firms with inordinate access to capital and IPO markets. The report includes some material already published here.

It’s the first English-language research report CFC has done in two years. For Chinese readers, some similar information has run in the two columns I write, for China’s leading business newspaper, the 21st Century Herald (click here “21世纪经济报道”) as well as Forbes China (click here“福布斯中文”) 

Despite all the success and the new money that is pouring in as a consequence, Chinese private equity retains its attractive fundamentals: great entrepreneurs, with large and well-established companies, short of expansion capital and a knowledgeable partner to help steer towards an IPO. Investing in Chinese private companies remains the best large-scale risk-adjusted investment opportunity in the world, bar none.

Oppo’s Titanic Achievement

August 8th, 2011 No comments

Leonardo DiCaprio does something in China that he dare not do in the US: peddle product. He is appearing now, unnamed but clearly recognizable, in ads for a Chinese domestic mobile phone brand called Oppo. His face is currently plastered all over my local subway station in Shenzhen.

It’s a bold move by a little-known Chinese mobile phone company to storm into the big time, and grab market share from Nokia, Samsung, LG and Apple. None of these global brands uses a big name to front its ads in China. Oppo is determined to compete as equals with these larger companies. It’s still learning the rules of building a successful brand. Its tactics and ad strategy are a little off-beat. But, Oppo has the resources and distribution in China to challenge the large global mobile phone brands, and so cause them headaches in the world’s largest mobile phone market.

The ads are a bit of a head-scratcher. They are framed to look like a strip of celluloid and feature, in the background, a European cobblestone street, a moped making a fast getaway while someone, maybe Leo, gives chase. The only text are the words “Find Me”, in English. In other words, it doesn’t have anything to do with mobile phones, not even subliminally. It looks like a movie poster. Still, seeing an A-List Hollywood star in a Chinese ad for a Chinese brand is no workaday occurrence.

Leo is hugely popular in China, especially among women under 40.  “Titanic” may well be the most-watched American movie of all time in China. No one knows for sure, since the movie came out in 1997, and circulated in China mainly through pirated video and DVDs.

Getting Leo to appear in the ads is quite a coup for Oppo. The Chinese company reportedly paid Dicaprio $5 million. A steep price, but the company is betting that Leo can pry open wallets in a way no other celebrity endorser can. The reason: Oppo is the only “girls only” major mobile phone brand in the world. The company’s phones are all aimed at, and advertised to, females.

Oppo’s phones are all  pretty standard, with no unique technology under-the-hood. But, they come in bright colors and feature girly do-dads like crystal keys. Oppo’s marketing, with the exception of the new DiCaprio ad, features Chinese women traveling in exotic locations, or chatting with friends.

Oppo is trying to pull off a challenging feat:  to catapult above the hundreds of no-name mobile phone manufacturers and brands, and establish itself as a premium brand in China. The other Chinese mobile phone brands do little to no advertising, and instead compete mainly on price. With its big ad budget and quirky strategy of targeting women from 18-40, Oppo aims to compete head-to-head with Samsung, Nokia and Apple.

Will it work? My guess is that Oppo will get a decent return for the $5 million spent on DiCaprio. The Chinese market is ready for a splashy self-confident Chinese domestic phone brand with some star power.

“Cometh the hour, cometh the man.”