China Private Equity

Two years back, I met the boss and toured the factory of a Shenzhen-based company called TMK Power Industries. They make rechargeable nickel-metal hydride, or Ni-MH,  batteries, the kind used in a lot of household appliances like electric toothbrushes and razors, portable “Dustbuster” vacuum cleaners, and portable entertainment devices like MP3 players. 

At the time, it seemed to me a good business, not great. Lithium rechargeable batteries are where most of the excitement and investment is these days. But, TMK had built up a nice little pocket of the market for the lower-priced and lower-powered NI-MH variety. 

I just read his company went public earlier this year in the US, through a reverse merger and OTCBB listing. I wish this boss lots of luck. He’ll probably need it.

Things may all work out for TMK. But, at first glance, it looks like the company has spent the last two years committing a form of slow-motion suicide. 

Back when I met the company, we had a quick discussion about how they could raise money to expand. I went through the benefits of raising private equity capital, but it mainly fell on deaf ears. The boss let me know soon after that he’d decided to list his company in the US.

He made it seem like a transaction was imminent, since I know he was in need of equity capital. Two years elapsed, but he eventually got his US listing, on the OTCBB, with a ticket symbol of DFEL. 

Here is a chart of share price performance from date of listing in February. It’s a steep fall, but not an unusual trajectory for Chinese companies listed on the OTCBB. 

From the beginning, I guessed his idea was to do some kind of reverse merger and OTCBB transaction. I knew he was working then with a financial advisor in China whose forte was arranging these OTCBB deals. I never met this advisor, but knew him by reputation. He had previously worked with a company that later became a client of mine. 

The advisor had arranged an OTCBB deal for this client whose main features were to first raise $8 million from a US OTCBB stock broker as “expansion capital” for the client. The advisor made sure there wouldn’t be much expanding, except of his own bank account and that of the stock broker that planned to put up the $8mn. 

Here’s how the deal was meant to work: the advisor would keep 17% of the capital raised as his fee, or $1.35mn.  The plan was for the broker to then rush this company through an expensive “Form 10” OTCBB listing where at least another $1.5 mn of the original $8mn money would go to pay fees to advisors, the broker,  lawyers and others. The IPO would raise no money for the company, but instead all proceeds from share sale would go to the advisor and broker. The final piece was a huge grant of warrants to this advisor and the stock broker that would leave them in control of at least 15% of the post-IPO equity. 

If the plan had gone down, it’s possible that the advisor and broker would have made 2-3 times the money they put up, in about six months. The Chinese company, meanwhile, would be left to twist in the wind after the IPO. 

Fortunately for the company, this IPO deal never took place. Instead, I helped the company raise $10mn in private equity from a first class PE firm. The company used the money to build a new factory. It has gone from strength to strength. Its profits this year will likely hit $20mn, four times the level of three years ago when I first met them. They are looking at an IPO next year at an expected market cap of over $500mn, more than 10 times higher than when I raised them PE finance in 2008. 

TMK was not quite so lucky. I’m not sure if this advisor stayed around long enough to work on the IPO. His name is not mentioned in the prospectus. It does look like his kind of deal, though. 

TMK should be ruing the day they agreed to this IPO. The shares briefly hit a high of $2.75, then fell off a cliff. They are now down below $1.50. It’s hard to say the exact price, because the shares barely trade. There is no liquidity.

As the phrase goes, the shares “trade by appointment”. This is a common feature of OTCBB listed companies. Also typical for OTCBB companies, the bid-ask spread is also very wide: $1.10 bid, and $1.30 asked. 

Looking at the company’s underlying performance, however, there is some good news. Revenues have about doubled in last two years to around $50mn. In most recent quarter, revenues rose 50% over the previous quarter. That kind of growth should be a boost to the share price. Instead, it’s been one long slide. One obvious reason: while revenues have been booming, profits have collapsed. Net margin shrunk from 13% in final quarter of 2009 to 0.2% in first quarter of 2010. 

How could this happen? The main culprit seems to be the fact that General and Administrative costs rose six-fold in the quarter from $269,000 to over $1.8mn. There’s no mention of the company hiring Jack Welch as its new CEO, at a salary of $6mn a year. So, it’s hard to fathom why G&A costs hit such a high level. I certainly wouldn’t be very pleased if I were a shareholder. 

TMK filed its first 10Q quarterly report late. That’s not just a bad signal. It’s also yet another unneeded expense. The company likely had to pay a lawyer to file the NT-10Q to the SEC to report it would not file on time. When the 10Q did finally appear, it also sucked money out of the company for lawyers and accountants. 

TMK did not have an IPO, as such. Instead, there was a private placement to raise $6.9mn, and in parallel a sale of over 6 million of the company’s shares by a variety of existing shareholders. The broker who raised the money is called Hudson Securities, an outfit I’ve never heard of. TMK paid Hudson $545,000 in fees for the private placement, and also issued to Hudson for free a packet of shares, and a large chunk of warrants.

Hudson was among the shareholders looking to sell, according to the registration statement filed when the company completed its reverse merger in February. It’s hard to know precisely, but it seems a fair guess that TMK paid out to Hudson in cash and kind over $1mn on this deal. 

The reverse merger itself, not including cost of acquiring the shell, cost another $112,000 in fees. At the end of its most recent quarter, the company had all of $289,000 in the bank. 

These reverse merger and OTCBB deals involving Chinese companies happen all the time. Over the last four years, there’s been an average of about six such deals a month.

This is the first time – and with luck it will be the only time – I actually met a company before they went through the process. Most of these reverse merger deals leave the companies worse off. Not so brokers and advisors. 

Given the dismal record of these deals, the phrase 美国反向收购 or “US reverse merger” , should be the most feared in the Chinese financial lexicon. Sadly, that’s not the case.

Since 2005, 380 Chinese companies have executed reverse mergers in the US. They did so, in almost all cases, as a first step towards getting listed on a major US exchange, most often the NASDAQ. Yet, as of today, according to a recent article in Dow Jones Investment Banker, only 15% of those Chinese companies successfully “uplisted” to NASDAQ. That’s a failure rate of 85%. 

That’s a rather stunning indictment of the advisers and bankers who promote, organize and profit from these transactions. The Chinese companies are left, overwhelmingly, far worse off than when they started. Their shares are stuck trading on the OTCBB or Pink Sheets, with no liquidity,  steep annual listing and compliance fees, often pathetically low valuations,  and no hope of ever raising additional capital. 

The advisors, on the other hand, are coining it. At a guess, Chinese companies have paid out to advisors, accountants, lawyers and Investor Relations firms roughly $700 million in fees for these US reverse mergers. As a way to lower America’s balance of payments deficit with China, this one is about the most despicable. 

You would think that anyone selling a high-priced service with an 85% failure rate would have a hard time finding customers. Sadly, that isn’t the case. This is an industry that quite literally thrives on failure. The US firms specializing in reverse mergers are a constant, conspicuous presence as sponsors at corporate finance conferences around China, touting their services to Chinese companies.

I was at one this past week in Shenzhen, with over 1,000 participants, and a session on reverse mergers sponsored by one of the more prominent US brokerage houses that does these deals. The pitch is always the same: “we can get your company listed on NASDAQ”. 

I have no doubt these firms know that 85% of the reverse mergers could be classified as expensive failures, because the companies never migrate to NASDAQ.  Equally, I have no doubt they never disclose this fact to the Chinese companies they are soliciting. I know a few “laoban” (Chinese for “company boss”)  who’ve been pitched by the US reverse merger firms. They are told a reverse merger is all but a  “sure thing”. I’ve seen one US reverse merger firm’s Powerpoint presentation for Chinese clients that contained doctored numbers on performance of firms it brought public on OTCBB.  

Accurate disclosure is the single most important component of financial market regulation. Yet, as far as I’ve been able to determine, the financial firms pushing reverse mergers offer clients little to no disclosure of their own. No other IPO process has such a high rate of failure, with such a high price tag attached. 

Of course, the Chinese companies are often also culpable. They fail to do adequate due diligence on their own. Chinese bosses are often too fixated on getting a quick IPO, rather than waiting two to three years, at a minimum, to IPO in China. There’s little Chinese-language material available on the dangers of reverse mergers. These kinds of reverse mergers cannot be done on China’s own stock exchanges. Overall knowledge about the US capital markets is limited. 

These are the points cited by the reverse merger firms to justify what they’re doing. But, these justifications ring false. Just because someone wants a vacation house in Florida doesn’t make it OK to sell them swampland in the Everglades. 

The reverse mergers cost China dear. Good Chinese SME are often bled to death. That hurts China’s overall economy. China’s government probably can’t outlaw the process, since it’s subject to US, not Chinese, securities laws. But, I’d like to see the Chinese Securities Regulatory Commission (中国证监会), China’s version of the SEC, publish empirical data about US reverse mergers, SPACs, OTCBB listings. 

There is not much that can be done for the 325 Chinese companies that have already completed a US reverse merger and failed to get uplisted to NASDAQ. They will continue to waste millions of dollars a year in fees just to remain listed on the OTCBB or Pink Sheets, with no realistic prospect of ever moving to the NASDAQ market.

For these companies, the US reverse merger is the capital markets’ version of 凌迟, or “death by a thousand slices”.

One of my hobbies at work is collecting outrageous stories about the greed, crookedness and sleaze of some financial advisors working in China. Sadly, there are too many bad stories – and bad advisors – to keep an accurate, up-to-date accounting. 

Over 600 Chinese companies, of all different stripes,  are listed on the unregulated American OTCBB. The one linking factor here is that most were both badly served and robbed blind by advisors.

Many other Chinese companies pursued reverse mergers in the US and Hong Kong.Some of these deals succeeded, in the sense of a Chinese company gaining a backdoor listing this way. But, all such deals, those both consummated or contemplated, are pursued by advisors to put significant sums of cash into their own pockets. 

Talking to a friend recently in Shanghai, I heard about one such advisor that has set a new standard for unrestrained greed. This friend works at a very good PE firm, and was referred a deal by this particular advisor. I’ve grown pretty familiar with some of the usual ploys used to fleece Chinese entrepreneurs during the process of “fund-raising”. Usual methods include billing tens of thousands of dollars for all kinds of “due diligence fees”, phony “regulatory approvals” and unneeded legal work carried out by firms affiliated with the advisor.  

But, in this one deal my Shanghai friend saw, the advisor not only gorged on all these more commonplace squeezes, as well as taking a 7% fee of all cash raised, but added one that may be rather unique in both its brazenness and financial lunacy. The advisor had negotiated with the client as part of its payment that it would receive 10% of the company’s equity, after completing capital-raising. 

Let’s just contemplate the financial illiteracy at work here.  No PE investor would ever accept this, that for example, their 20% ownership immediately becomes 18% because of a highly dilutive grant to the advisor. It’s such a large disincentive to invest that the advisor might as well ask the PE firm to surrender half its future profits on the deal to put the advisor’s kids through college.

The advisor clearly was a lot more skillful at scamming the entrepreneur than in understanding how actually to raise PE money. The advisor’s total take on this deal would be at least 17% of the investor’s money, factoring in fees and value of dilutive share grant. 

By getting the entrepreneur to agree to pay him 10% of the company’s equity, along with everything else, the advisor raises the company’s pre-money valuation by an amount large enough to frighten off any decent PE investor. Result: the advisor will not succeed raising money, the entrepreneur wastes time and money, along with losing any real hope of every raising capital in the future. What PE firm would ever want to invest with an entrepreneur who was foolish enough to sign this sort of agreement with an advisor? 

This is perhaps the most malignant effect of the “work” done by these kinds of financial advisors. They create deal structures primarily to enrich themselves, at the expense of their client. By doing so, they make it difficult even for good Chinese companies to raise equity capital, now and in the future.  

I’m sure, based on experience, that some people reading this will place blame more on the entrepreneur, for freely signing contracts that pick their own pockets. No surprise, this view is held particularly strongly by people who make a living as financial advisors doing OTCBB and reverse merger deals in China.  This view is wrong, professionally and morally. 

In most aspects of business life, I put great stock in the notion of “caveat emptor”. But, this is an exception. The advisors exploit the credulity and financial naivete of Chinese entrepreneurs, using deception and half-truths to promote transactions that they know will almost certainly harm the entrepreneur’s company, but deliver a fat ill-gotten windfall to themselves. 

Entrepreneurs are the lifeblood of every economy, creating jobs, wealth and enhancing choice and economic freedom. This is nowhere more true than in China. Defraud an entrepreneur and, in many cases,  you defraud society as a whole. 

“Manage people’s expectations. Then, exceed them.” That’s not a bad rule to live by, or management principle to apply in regulating China’s fast-moving capital markets. This past week, China Regulatory Securities Commission, the nation’s stock market regulator, moved one step closer to opening trading in the new, Shenzhen-based, Growth Enterprise Market. It’s been ten years in the planning. The names were finally announced of the first companies that will list on the new market when trading begins later in October. All are private SME, and several had pre-IPO private equity funding.

The total amount of capital this first crop of IPOs will raise is well above most earlier estimates. The original stated plan was for smaller companies to list on the GEM, which, in turn, suggested the GEM market would be only a marginal contributor of growth capital for private SME. The minimum requirement was set at just $1.5mn in aggregate profits over the last two years. Even at high Chinese multiples, firms of that size would struggle to raise more than $10mn in an IPO.

But, in something of a surprise, CSRC chose larger companies to be in the first group to list. It now looks like that the ten companies will raise a total of over $400mn when their IPOs close, or an average of $40mn each. This, in turn, points to a cumulative market capitalization for this first group of around $2 billion. That bodes well for the market’s long-term future. A larger market capitalization means more liquidity and so less volatility in the share price. This will help attract more capital to the new Shenzhen market, and to subsequent future IPOs there.

Bravo, I say! The CSRC may well get the formula right, and so prove that these smaller-capitalization “growth stock markets” can work, both for companies and investors.

Elsewhere, these growth stock markets have mainly failed in their stated purpose to create an efficient platform for smaller companies to attract investors and raise capital. Germany’s Neuer Markt shut down soon after it was created. The small-cap markets in Singapore and Hong Kong have been disappointments. Small-cap companies stayed small-cap companies, which is entirely contrary to the purpose of a “growth board” like this. The granddaddy of them all, America’s OTC Bulletin Board, has become an all-purpose dumping ground for shady American firms, stock manipulators, and, sadly, several hundred once-strong Chinese SME who listed there after taking very bad advice from self-interested advisors and brokers looking to make a quick buck.

It’s anybody’s guess how many companies will list on Shenzhen’s GEM this year, or next. There is a backlog of at least 100 that have applied, and been provisionally accepted by CSRC. One thing we know: each IPO in China will get its final approval as part of an orderly process that takes into account the performance of companies already listed on GEM, and stock prices trends overall.

The Shenzhen GEM shows every sign of beginning to fill a very large, very important funding gap in China. Assuming, as I hope, that CSRC continues its preference for companies able to raise at least $30mn-$40mn in a public listing, these IPOs will channel capital to companies who would otherwise find it very hard to come by. Most of the private equity and venture firms that we work with don’t write checks that large. They generally invest around $10mn-$25mn in pre-IPO equity capital to own 20%-30% of a private Chinese SME. These investments are done at valuations of around eight times last year’s profits. So, a GEM listing could become the best source of growth capital for an SME that already has achieved some success, has profits of over $10mn-$20mn a year, but is still too small for a main board listing, in China or outside.

The public markets have two big advantages over private equity financing: they offer much higher price-earnings valuations, and give shareholders a liquid market to trade their shares. On the other hand, for Chinese SME, staging an IPO in China always has a level of deep unpredictability. The CSRC makes all the decisions about which companies can IPO and when. So, SME can wait two years or more to apply, get approval, and then put the IPO proceeds in the bank. If that SME is now growing quickly, has outsized opportunities near-to-hand with a high rate of return, but can’t finance its growth internally or with bank debt, a round of private equity will almost certainly be the best route to follow.

Done right (see my earlier blog post, on Foshan Saturday ’s IPO) a company’s market capitalization, when it eventually completes its IPO, can be at least three times larger than it is at present. That means the laoban gets richer (nothing wrong with that), and investors are happier, too, because of the increased liquidity and stability from the higher market cap at IPO.

I’m extremely positive about the role the GEM will play in helping to build even stronger private Chinese SME. The CSRC and Chinese government have taken over ten years to plan this new stock market, and learn from the mistakes of others. All signs now are that they have done so, and the GEM will gradually create a group of publicly-traded private companies that will go on to achieve far more impressive results in the future.

I’m a pretty even-tempered guy, for the most part. But, those who know me, or read this blog, will by now know that I have a rather lively contempt for the financial advisors who swarm all over China, coaxing Chinese SME to pay them huge sums to arrange an IPO. Most often, the IPO happens as quickly as possible, with maximum fees flowing to the advisors, often on the shabbiest, most illiquid and unregulated of all stock markets, the American Over-the-Counter Bulletin Board (OTCBB). 

So, it was with a mix of surprise and, to be honest, some annoyance that I found myself recently besieged by some of these same “financial advisors”, eager to become my friend and business partner. It happened at the PE Conference I attended in mid-July in Shanghai. I was there to give one of the keynote speeches. Overall, it was a great experience. The organizers were cordial and professional. The other speakers and panel-members were first-class. 

But, I occasionally felt like a bit of bait dangling on hook. At every break, I was approached by well-dressed and well-spoken people, eager to give me their business cards, and talk shop. It just so happened that the shop they wanted to talk about was how to revive their now-troubled business model of doing these quick and lucrative IPOs for Chinese companies. I quickly, and I hope politely, explained that they were anathema, and in my mind, deserved particularly excruciating forms of punishment for ruining so many otherwise-good Chinese businesses by promoting and profiting from these awful IPO deals. Boiling in oil perhaps?  

Now, sure, these people didn’t have any way of knowing how I felt about what they do. They’ve never seen my blog, or heard me hold forth on the subject. So, I guess they must have found my reaction a little extreme. But, it did put a more human face on this whole problem, which I believe to be the single worst aspect of China’s financial system, that unethical and unprincipled advisors run rampant here, and have succeeded in convincing so many Chinese companies to IPO for the wrong reasons, at the wrong time, at grotesque expense with disastrous results.   

To be honest, I was a little surprised at just how nice and professional many of these “financial advisors” at the conference seemed to be. They didn’t conform very well to my stereotype, which admittedly, was formed by a quick meeting with one of these advisors almost two years ago. This was the guy who had tried, and nearly succeeded, to lure a great Chinese company to destruction via a “Form 10 Listing” on the OTCBB. This company later became China First Capital’s first client. 

The advisors I met at the conference were mainly eager to talk about how much they liked and respected CFC’s approach, and how much they had to learn from us. What is it they say about flattery being the food of fools? Anyway, soon after, they usually then started pitching me on some company or other that they were trying to list. One of them explained that they were now trying to get into the business of raising PE capital for Chinese SME. Did I have any tips? 

In this case, my advice was to disclose to these SME their past record of copping fat fees for taking companies public, knowing these clients would likely wither and die after the IPO. 

One thing that did strike me, in talking to these guys, is that they all tended to use the same Chinese phrase to describe their clients: “上市公司”, which I’d translate as “an IPO company”. It’s actually quite apt.  They are in business to arrange IPOs, not generally to raise capital, or act as bankers or trusted long-term advisors. 

We have some similar kinds of organizations in the US, and they often delusionally will call themselves “investment banks”. What they are, more accurately, are IPO bucket shops. In China, they still mainly call themselves “FA”, short for “Financial Advisor”. 

By whatever name, these guys are likely to remain a problem in China for a long time. They will not go out of business just because I hectored them about the damage they’re doing to entrepreneurship in China.  There are too many of them, and too many good SME for them to prey upon. They are like a well-oiled machine for mangling good Chinese companies.

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One of the main themes of the PE conference I attended last week in Shanghai was the launch of the Shenzhen Stock Exchange’s new Growth Enterprise Market “GEM”, for smaller-cap, mainly high-tech companies.

It’s been a long time in the planning – since at least 1999. In March 2008, China’s Prime Minister, Wen Jiabao, tried to kickstart the process and announced plans to open soon this second market in Shenzhen. Events then intruded – the credit crisis struck, financial markets tanked, and so plans for China’s GEM went into limbo.

Things are now back on track. Trading is likely to begin in October. At the conference, most of the speakers focused on hows and whys the GEM would open new opportunities for smaller companies to raise money from China’s capital market.

Overall, it’s a development I applaud. Private companies in China are often starved of growth capital, and the GEM will mean more of the country’s capital gets allocated to these businesses.

There is one aspect, however, of the GEM that I personally find a little less positive. It’s a small quibble, but my concern is that the opening of the GEM will lead still more Chinese companies to divert time and resources away from building their profits and market share and instead devote energy and cash towards going public. The smaller the company, the more potentially harmful this diversion of attention can be.

China is, to use a military analogy, a “target-rich environment”. Companies often have more opportunities than they have time or resources. This is the product of an economy growing very strongly (8% this year) and modernizing at lightning speed. Large companies can also suffer when they shift focus from gaining customers to gaining a public listing. But, they will usually operate in an established market with established customers. This gives them more of a cushion.

Smaller, high-tech companies don’t have as much leeway. For these companies (last year’s revenues under $5o million) the risk is that the time-consuming and expensive process of planning an IPO on GEM will severely impact current operations, causing it to miss chances to expand, and so lose out to better-focused competitors.

In other words, there’s a trade-off here that tends to get overlooked in all the excitement about the opening of this new stock market in China. The trade-off is between focusing on capital-raising and focusing on building your business.

In my experience, private Chinese companies are already often a little too fixated on an IPO. It’s the main reason so many have made the poor, and often fatal, choice to go public on the American OTCBB. The GEM, I fear, will add fuel to this fire. Often, the best choice for a fast-growing private Chinese company will be to ignore the many pitches they’ll hear from advisors to IPO, and hunker down by focusing on their business for the next year or two.

Yes, being a boot-strapped company is tough. There’s never enough cash around. I know this at first-hand, since along with running China First Capital, I’m also CEO of a boot-strapped security software company in California, Awareness Technologies. Our growth opportunities far exceed our ability to finance them. So, I can understand why the thought of raising an “easy” $5 million – $15 million by going public on the GEM is very attractive to any Chinese boss running a similar cash-short and opportunity-rich company.

But, capital always has a cost. In this case, the main costs will be both the cash paid to advisors and regulators, along with the indirect cost of being a beat slower to seize available opportunities to grow. In China at the moment, any slowness is not just a problem. It can be life-threatening. Every business here operates in a hyper-competitive marketplace.

Of course, any company that can raise money by going public on the GEM will eventually enjoy a big advantage over competitors. It will have the cash and the stronger balance sheet to finance growth. But, the IPO process in China remains far slower than in the US or Hong Kong. A company planning and funding its GEM IPO now, may need to wait two years or more to get all necessary approvals and so finally raise that money with an IPO. Meantime, competitors are, as Americans like to say, eating this company’s lunch.

It’s a discussion we often have with SME bosses – how to time optimally an IPO. A rule of thumb with IPOs is: “small is not beautiful.” Going public on the strength of still limited earnings and revenues will likely result in a small market cap. This can adversely affect share price performance, and so limit the company’s ability to raise additional equity capital. To avoid this trap, it’s often going to be better to wait. Let competitors get bogged down in IPO planning. You can then grow at their expense.

In one way, though, the establishment of the GEM market is an unqualified triumph. It sends the signal far and wide that private SME companies will play an ever larger role in fueling the growth of China’s economy.

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In recent years, a large percentage of all OTCBB IPOs have been for Chinese SME companies. This is largely because too many Chinese SME fall too easily into the pit of investment vipers – the lawyers, accountants and self-described “investment bankers” and “private equity investors” that promote these OTCBB listings, reverse mergers and other schemes concocted by advisors generally for their own self-enrichment.

Once caught in the trap, the prospects for the SME are generally pretty bleak. They’ll be bled of badly-needed cash to pay the advisors, bankers and lawyers their fees, and later, by the costs of remaining a listed company. The bosses come to learn that a “US IPO” isn’t at all what it’s cracked up to be when it takes place on OTCBB: there are no celebratory news reports, no huge sums flowing into their personal or corporate bank accounts, no boost in company prestige or brand awareness. At best, it turns out to be a very expensive lesson. At worst, it’s the transaction that leads to the company’s premature demise.

Of course, by the time the SME realizes the scale of the mistake it made by agreeing to IPO on OTCBB, the advisors, lawyers and bankers are all long gone. I’ve heard from a Chinese lawyer friend that these advisors will change their mobile phone numbers after the IPO so the SME boss can no longer contact them.

Indeed, the distinguishing characteristic of these advisors and bankers is their disregard for the future condition of the Chinese SMEs once they’ve done the OTCBB transaction. They have no stake in the long-term success of the company, because they cash out at IPO, and move onto their next victim, er client.

It is not unusual that advisors earn millions of dollars from these OTCBB deals. It may be the most successful and durable investment banking racket of all time. Hundreds of Chinese companies have been ensnared over the last seven years.

How has it gone on for so long? For one thing, the OTCBB is not regulated in any real sense of the word. So, the SEC has little or no power to crack-down. The larger factor, though, is the complete lack of adequate scrutiny by the Chinese SME bosses. They put their business’s future in the hands of a bunch of guys with a proven talent (and mile-long rap sheets) for destroying companies, not building them.

I’m constantly amazed that great Chinese SME bosses I’ve met will do no independent due diligence on financial advisors. They don’t ask for a full track record of past deals, or partner bios, or a list of satisfied past customers to consult. Everything is taken at face value, and appropriately enough, the common result is a very large loss of face for the Chinese boss, after these bad deals have closed, and the damage is calculated.

Even if a Chinese boss wanted to do some proper due diligence, it’s by no means simple. There’s a notable lack of good, current information about the OTCBB in Chinese. Chinese journalists don’t ever seem to write about it, perhaps because these IPOs take place outside China. I did a search of OTCBB on China’s main search engine, Baidu.com, and the top results included information that’s three to four years old, and a site called OTCBB.com.cn that offers very little information, and seems to be owned and run by the kind of advisory firm that specializes in (you guessed it) doing OTCBB listings of Chinese companies. You won’t find anything too useful here.

It doesn’t take a lot of digging, assuming one can speak some English and knows where to look, to discover information that should start alarm bells ringing loud enough to wake the dead. For example, the Chinese government doesn’t recognize the OTCBB as a legitimate stock market for many transactions. Here’s a kernel of disclosure language from the SEC filing of a Chinese company that listed on OTCBB. (Underlined for emphasis:)

“The stock portion of the purchase price of Weihe to Weihe’s stockholders because the delivery of shares of the Company’s common stock in connection with the acquisition of Weihe is not permitted pursuant to applicable PRC law, so long as the Company is listed and traded on the OTCBB, rather than an exchange recognized by the applicable PRC governmental authorities, such as Nasdaq, AMEX and the NYSE.”

Imagine for a second you’re a lawyer, working with a Chinese SME on a proposed OTCBB listing. You must know this fact, that the Chinese government doesn’t recognize that stock market as legitimate. What do you do? Do you exercise your duty-of-care, and tell the client of the danger of an OTCBB listing? Or, do you just gloss over it, so that the deal will go through and you’ll earn big legal fees?

No prizes for guessing which course many of the lawyers take who advise Chinese SME on OTCBB listing. This is why it’s not, in my mind, exaggerating to say that these advisors are often a disgrace to their professions.

What can be done about all of this? It’s already too late for hundreds of Chinese companies that went down this road. For the other thousands of good SME bosses, however, access to better information in Chinese is obviously going to be important, to give them a solid basis to decide which kind of capital markets transaction to pursue.

I’ve done my share lately of cursing the darkness in this blog, remonstrating against the advisors, lawyers and bankers who’ve grown rich off promoting OTCBB and Pink Sheet listings, reverse mergers and SPAC deals. It’s time I also lit a candle.

Together with my colleagues at China First Capital, we’ve been working on a Chinese-language publication called “如何选择上市的时机和地点” or “When and Where to IPO”. It discusses at some length the problems with listing on OTCBB, or doing other kinds of rushed IPOs.

We’ll be completing it this week, and once done, we’ll do our utmost to make it as widely available as possible, in print and online.

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Market capitalization plays a very important part in the success and stability of a Chinese SME’s shares after IPO. In general, the higher the market capitalization, the less volatility, the more liquidity. All are important if the shares are to perform well for investors after IPO.

There is no simple rule for all companies. But, broadly speaking, especially for a successful IPO in the US or Hong Kong, market capitalization at IPO should be at least $250 million. That will require profits, in the previous year, of around $15mn or more, based on the sort of multiples that usually prevail at IPO.

Companies with smaller market capitalizations at IPO often have a number of problems. Many of the larger institutional investors (like banks, insurance companies, asset management companies) are prohibited to buy shares in companies with smaller market capitalizations. This means there are fewer buyers for the shares, and in any market, whether it’s stock market or the market for apples, the more potential buyers you have, the higher the price will likely climb.

Another problem: many stock markets have minimum market capitalizations in order to stay listed on the exchange. So, for example, if a company IPOs on AMEX market in the US with $5mn in last year’s profits, it will probably qualify for AMEX’s minimum market capitalization of $75 million. But, if the shares begin to fall after IPO, the market capitalization will go below the minimum and AMEX will “de-list” the company, and shares will stop trading, or end up on the OTCBB or Pink Sheets. Once this happens, it can be very hard for a company’s share price to ever recover.

In general, the stock markets that accept companies with lower profits and lower market capitalizations, are either stock markets that specialize in small-cap companies (like Hong Kong’s GEM market, or the new second market in Shenzhen), or stock markets with lower liquidity, like OTCBB or London AIM.

Occasionally, there are companies that IPO with relatively low market capitalization of around RMB300,000,000 and then after IPO grow fast enough to qualify to move to a larger stock market, like NASDAQ or NYSE. But, this doesn’t happen often. Most low market capitalization companies stay low market capitalization companies forever.

Another consideration in choosing where to IPO is “lock up” rules. These are the regulations that determine how long company “insiders”, including the SME ownerand his family, must wait before they can sell their shares after IPO. Often, the lock up can be one year or more.

This can lead to a particularly damaging situation. At the IPO, many investment advisors sell their shares on the first day, because they are often not controlled by a lock up and aren’t concerned with the long-term, post-IPO success of the SME client.  They head for the exit at the first opportunity.

These sales send a bad signal to other investors: “if the company’s own investment advisors don’t want to own the shares, why should we?” The closer it gets to this time when the lock up ends, the further the share price falls. This is because other investors anticipate the insiders will sell their shares as soon as it becomes possible to do so.

There are examples of SME bosses who on day of IPO owned shares in their company worth on paper over $50 million, at the IPO price. But, by the time the lock up ends, a year later, those same shares are worth less than $5mn. If it’s a company with a lot market capitalization, there is probably very little liquidity. So, even when the SME bosshas the chance to sell, there are no buyers except for small quantities.

The smaller the market capitalization at IPO, the more risky the lock-in is for the SME boss. It’s one more reason why it’s so important to IPO at the right time. The higher an SME’s profits, the higher the price it gets for its shares at IPO. The more money it raises from the IPO, the easier it is to increase profits after IPO and keep the share price above the IPO level.   This way, even when the lock up ends, the SME boss can personally benefit when he sells his shares.

Of all the reasons to IPO, this one is often overlooked: the SME boss should earn enough from the sale of his shares to diversify his wealth. Usually, an SME boss has all his wealth tied up in his company. That’s not healthy for either the boss or his shareholders. Done right, the SME boss can sell a moderate portion of his shares after lock in, without impacting the share price, and so often for the first time, put a  decent chunk of change in his own bank account.

We give this aspect lot of thought in planning the right time and place for an SME’s IPO. We want our clients’ owners and managers to do well, and have some liquid wealth. Too often up to now, the entrepreneurs who build successful Chinese SMEs do not benefit financially to anything like the extent of the cabal of advisors who push them towards IPO. 

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The timing of IPO is the most important question for all Chinese SME preparing for a public listing. Unfortunately, the correct answer is often the one most rarely heard. Instead, many investment bankers and advisors in China tell the SME boss that an IPO should be scheduled “as soon as possible”.

This is often music to the bosses untrained ears, since they’re wrongly assuming that the proceeds of an IPO will go directly into their pockets – a misconception these same investment bankers and advisors can literally cash in on. They’ll tell the SME boss the “bad” news — that the IPO proceeds must go to the company not to his personal bank account, and that the boss won’t be able to sell any of his own shares for a year or more after the IPO – towards the end of the expensive pre-IPO planning process, when it’s usually too late to pull out, without losing a huge amount of money.

This is if they bother to mention it at all. I’ve heard of instances where the Chinese boss is never told directly by his investment bankers, lawyers and advisors, but only finds out if his staff prepares a Chinese translation of the SB-2 prospectus used in OTCBB listings.

So, if not “right away”, what is the correct answer to the question: “when should a Chinese SME IPO”? Of course, circumstances will differ for each company. But, as a general principle, an IPO should come at the apex of an SME’s growth curve, when the company is achieving its historical highest return on equity and return on investment. This way, the SME will get a fuller value for its shares when it does list them publicly.

This also explains why pre-IPO private equity can have such a key role to play in the process. The purpose: put more capital to work than the company can generate internally, or can borrow from banks. This equity capital is then invested where it will earn the highest return over a two to three year period – for example, increasing production and improving economies of scale, or accelerating the pace of opening new distribution outlets.

The PE firm will also help improve efficiencies – in their role as risk-sharing partner with the SME boss – that can lead to significant improvement in net margins. In most cases, the pre-IPO PE capital can result in a doubling of profits. Done right, the pre-IPO capital will result in only modest level of dilution for existing owners – usually no more than 25%. It’s like switching on the after-burners: the SME can speed up its growth, improve its margins, seize large available market opportunities, and so position itself for a far more successful IPO in two to three years’ time.

An IPO has one great value above everything else: it will be the cheapest and most efficient way for an SME to raise the capital it needs to expand its business. The shares will likely be valued at multiples two times higher than a pre-IPO PE investor will pay. Since the amount of capital raised will be a multiple of profits, the higher the profits at IPO the better.

To illustrate this, let’s imagine a company with profits last year of RMB75 million. It has its IPO now, at a PE of 15 and its market capitalization at IPO is RMB 1,125,000,000. The company sells 25% of its shares in the IPO, and so it raises RMB 281,250,000. If instead the company waits another year, it raises a RMB50 million of pre-IPO private equity to help push its profit growth. A year later, profits have reached RMB120 million. If the company now has its IPO, at the same PE of 15, and sells 25% of the shares, it will raise RMB450,000,000 or 60% more.

Let’s  assume  the company continues to maintain a high return-on-investment, after IPO. If so, the more money raised at IPO, the higher profits should be able grow in the future. This is perhaps the most important predictor of overall share performance after IPO. By waiting to IPO, so that its size and profits would be larger, this company will be able to raise much more at IPO and so continue generate higher profits for many years into the future.

A company can IPO only once. So, it is important to raise the optimal amount during this one IPO. If a company IPOs too early, it will sacrifice its ability to finance its growth in the future. Many of the most successful IPOs in China were for private SME companies that had pre-IPO investment from private equity companies: Baidu, Alibaba, Suntech, Belle. That isn’t a coincidence. It’s the result of the sort of smart IPO-planning that is too rare in China.

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My last two posts have elicited an unusual amount of feedback. The posts deal with the underhandedness, deceit, negligence and shameless greed of so many of the advisors, lawyers and investment bankers doing IPOs of Chinese companies outside China. 

It’s always nice to get mail. Well, mostly. A lot of the comments and emails were complimentary. But, probably half of the email traffic came from various ethically-challenged financial advisors, brokers, lawyers and fixers asking to work with me on their different China IPO schemes. All of them were, from what I could tell, the sort of transactions I railed against in my recent posts – particularly OTCBB listings, reverse mergers. In other words, the same people I would like to see neutered wrote to see if I wanted to go whoring around with them. 

I even got invited to a reverse merger conference in Las Vegas — hard to decide which part I’d least prefer, the conference or the setting.

In one sense, this is more than a little depressing. Either these guys hadn’t understood what I wrote, or figured I would be a useful shill for them somehow: “Look, we even convinced that guy Fuhrman who criticized OTCBB listings to get in on the game.” If so, they seriously miscalculated. 

There is another, more hopeful explanation for these wildly off-target emails. I know that times have gotten very tough for this whole crowd who made all the money wrecking what were often quite promising Chinese SME companies by convincing them to do bad IPO deals. The stock market, of course, is still limping, and most IPO activity (both the good and the debased) has all but dried up. 

Perhaps, then,  these emails to me are a last dying gasp, a tangible sign that the low practices that flourished over the last ten years are doomed. That would be great news, that bad advisors are contacting me as a last resort, because they’ve tried everything else and failed to revive a once-lucrative franchise fleecing good Chinese companies. 

You know what they say about things that sound too good to be true… We’ll see. 

For the record, as well as for those who may harbor any lingering hope I might be able to revive their business doing OTCBB listings or reverse mergers, I wanted to set out, clearly, what it is we do:

Now, I can imagine what a few of my recent email correspondents must be thinking, “What a dope. Why would anyone bother with this ‘high integrity’ stuff when you can make a fortune pushing Chinese companies through the IPO meat grinder?” 

That sort of approach, of grabbing fees while mutilating your client,  is so far removed from what I built China First Capital to do that it’s like asking a ballerina to enter a demolition derby. I’m lucky (or crazy, take your pick), but I didn’t start CFC with the primary motive of making money. I started it for three reasons:

(1) to have a chance, after achieving some career success elsewhere, to give something back to China, a country that’s been the deep and abiding love of mine since I was a little boy;  (2) to work alongside world-class founder/entrepreneurs, and help them get the financing they need to go farther and faster, and so become industry leaders in China over the next 10-20 years; and (3) to provide Chinese SMEs with at least one alternative to the sort of noxious advisory firms that have preyed on them for over 10 years. 

It’s demanding work. We refuse to cut corners, or get involved with a deal because there’s easy money to be made. We view our clients as our partners, not as a meal ticket.  In all these ways, I know I come from a different planet than the guys who arrange OTCBB deals, reverse mergers, or other quickie IPOs.

There’s another difference: I feel profoundly lucky every day to do what I get to do. I doubt they do. 

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My last post dealt with the often-unprincipled conduct of the advisors, bankers and lawyers who created many of the disaster stories among Chinese SME companies seeking a stock-market listing. It’s not a topic that will win me a lot of friends and admirers among the many advisors, lawyers, and investment banker-types still active, sadly, sponsoring OTCBB and reverse merger deals in China. In my experience, they tend to put the blame elsewhere, most often on Chinese bosses who (in their view) were blinded by the prospect of quick riches and so readily agreed to these often-horrible transactions. 

There’s some truth to this, of course. But, it’s a little like a burglar blaming his victim for leaving a second-story window unlocked. Culpability – legal and moral – rests with those who are profiting most from these bad IPO deals. That’s the advisers, bankers and lawyers.  They are the ones getting rich on these deals that, too often, leave the Chinese company broken beyond repair. 

The bad IPO deals are numerous, and depressingly similar. I don’t make any effort to keep tabs on this activity. I usually only learn specifics if I happen to meet a Chinese SME boss who has had his company crippled by doing an OTCBB listing or reverse merger, or an SME that is in the process of doing a deal like this. 

Here are a few “case studies” from among the companies I’ve met. They make for depressing reading. I’m omitting the names of the companies and their advisers.  The investment bankers on these deals deserve to be publicly shamed (if not flogged) for what they’ve done. But, the stories here are typical of  many more involving crooked investment bankers and advisers working with Chinese SME. The story lines are sadly, very familiar. 

COMPANY 1

A Guangdong electrical appliance company, with 1,500 employees, had 2008 revenues of $52mn, and net profit of $4mn, did a “reverse merger” in 2007 and then listed its shares on the OTCBB. Despite the company’s good performance (revenues and profits grew following the IPO), the share price fell by 90% from $4.75 to under 5 cents. At the IPO, the “investment advisors” sold their shares. The company also raised some cash, about $8mn in all.  But, quickly, the share price started to fall, and the market capitalization fell from high of $300mn to under $4mn. The company’s management didn’t have a clue how to manage a US publicly-traded company (none spoke English, for one thing), and so started making regulatory mistakes and had other problems with filing SEC documents. The company’s management, still with much of the $8mn raised in the IPO in its corporate bank account,  then started selling personal assets at wildly inflated prices to the company, and so used these related party transactions to take most of the remaining cash from the business into their pockets. No surprise, the company’s auditors discovered problems during its annual SEC audit, and then resigned.

The company’s share price is so low it triggered the “penny stock” rules in the US, which limit the number of investors who are allowed to buy the shares.

COMPANY 2

An agricultural products company with $73 million in 2008 revenues chose to do a “reverse merger” in the US, to complete a fast IPO early in 2009. The company got the idea for this reverse merge from an investment adviser in China who promised to raise $10 million of new capital as part of the reverse merger. The agricultural products company believed the promise, and spent over $1 million to buy the listed US shell company, including high fees to US lawyers, accountants and advisers.   

After buying the shell and spending the money, the company learned that the advisor had failed to raise any new capital. The company now has the worst possible situation: a listing on the OTCBB, with no new capital to expand its business, a steadily falling share price, and annual costs of being listed on the OTCBB of over $500,000 a year. At this point, no new investor is likely to invest in the company, because it already has a public listing, and a very low share price.

Because of this reverse merger, the company’s financial situation is now much worse than it was in 2008, and the company’s founder effectively now has no options to finance the expansion of his business which, up until the time of this reverse merger, was thriving.

 COMPANY 3

In 2008, an outstanding Guangdong SME manufacturing company signed an agreement with a Guangdong  “investment advisor” and a small US securities company that specializes in doing “Form 10 Listings” of Chinese SME on the OTCBB. They told the company’s boss they were a “Private Equity firm”. The investment advisor and the US securities company were working in concert to take as much money from this company as possible. Their contract with the company gave them payments of over $1.5 million in cash for raising $6mn for the company, a fee of 17%, and warrants equal to over 20% of the company’s shares. The $6mn would come from the securities company itself, so it could claw back a decent chunk of that in capital-raising fees, and also grab a huge slug of the equity through warrants. 

The securities company quickly scheduled a “Form 10” IPO for summer of 2008, and arranged it so the shares to be sold would be the warrants owned by this securities company and the Chinese investment advisor. So, according to this scheme, the Chinese SME would have received no money from the IPO, and all the money (approximately $10 million) would have gone direct to the securities company and the advisor.

The securities company deliberately misled the SME founder into thinking his shares would IPO on NASDAQ. Further, they gave the founder false information about the post-IPO performance of the other Chinese SME they had listed through “Form 10 Listings” on the OTCBB. Most had immediately tanked after IPO. 

In this case, the worst did not happen. I had met the boss a few months earlier, through a local bank in Shenzhen, and liked him immediately.  Before the IPO process got underway, I offered him my help to get out of this potentially terrible transaction. This was before I’d set up China First Capital, so the offer really was one of friendship, not to earn a buck. I promised him if he could get out of the IPO plan, I’d raise him money at a much higher valuation from one of the best PE firms in China. 

The boss was able to cancel the IPO plan, and I started China First Capital with the first goal of fulfilling my promise to this boss.  CFC quickly raised the company $10mn in private equity from one of the top PE companies , and the valuation was over twice the planned IPO valuation from the “investment advisor” and the securities company. This SME used the $10mn in pre-IPO capital to build a new factory to fill customer orders. 2009 profits will double from 2008. The company is on path to an IPO in 2011, and at that time, the valuation of the company will likely be over $300mn, +7X higher than at the time of PE investment.

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Back again in Shenzhen, with plenty of food for thought, as well as food for the belly. I go through the same “immersion program” whenever I arrive back here: it involves stopping for a plate of dumplings or bowl of noodles once every 30 paces. Or anyway, it certainly seems that way. 

The food for thought, as always, centers on ways to deliver enhanced value and service to clients and business partners. We have a set of core principles, that we build our business on, and that collectively represent our main differentiators. They are disarmingly simple – to work with integrity and honesty,  and always put the success of our clients’ first. We know that if we do this, our own success will follow. 

Simple, but not nearly as universal as they should be in our business. A lot of investment banking, IPO and advisory work in China has bordered on the criminal. Hundreds of SME companies were damaged, if not destroyed, by advisors, lawyers and others who neglected entirely to put their clients’ interests first. Instead, they pushed for companies to take various fast routes to IPO in the US, typically reverse mergers, OTCBB Listings, Form 10, SPAC deals. The reason: the advisors, lawyers, bankers all made a pile of money, quickly, through these kinds of deals. When things turned sour, as they often did, the advisers, bankers and lawyers were generally nowhere to be found, and the Chinese companies were left in dire straits.

Obviously, the bosses of the Chinese companies were complicit, since they agreed to these kinds of schemes to achieve a fast IPO. But, in my experience, the bosses main sin was that of ignorance. They simply didn’t understand all the workings of these kinds of deals, or even the fee-structure that would disproportionately reward the advisers, lawyers and bankers. In other words, the Chinese bosses didn’t do their DD, didn’t check the dismal track record of the many Chinese companies that already opted for OTCBB listings or reverse mergers.

I sometimes think the Chinese term for IPO, “上市” ( “shang shi”) has magical, intoxicating effect on some Chinese bosses. They hear it and suspend all their normal caution and suspicion. Soon, they end up agreeing to what are often truly disastrous transactions that don’t even deserve the name IPO.

There are, by some estimates, several hundred Chinese companies now listed on the OTCBB that are somewhere between “on life support” and “clinically dead”. Their share prices fell steeply immediately after listing (by which time the advisers, bankers and lawyers all pocketed their fees and lined up their next victims) and are below $1. There is little to no liquidity. They often trade at PE multiples of 1-2x. The costs of retaining the OTCBB listing are bleeding the companies of badly-needed money. They have no chance to raise additional capital, nor to do much of anything (except waste money on Investor Relations firms) to lift their share price.

I get angry just thinking about this. I’m offended that people in my field of work would be involved in such self-serving, greed-ridden transactions. Secondly, it’s also brought a lot of harm, and sometimes complete failure, to what were very good Chinese SME companies that once had bright futures, until they had the misfortune of putting their financial futures in the hands of these advisors.

Of course, the guiding principle behind all investment decisions must be “caveat emptor”. Chinese bosses clearly didn’t “caveat” enough. That’s regrettable. But, the gains made by the advisors, lawyers and bankers were so enormous, and so ill-gotten. That’s the heart of the matter: Chinese companies were ruined so that a bunch of ethically-challenged finance people could get rich.  For me, this is contemptible.  How these people sleep at night I don’t know.

I do know this: we try to do everything we can to make it less likely that a good Chinese SME goes the same route, and ends up in the same sad condition. One way is through information. We’re producing Chinese-language materials meant to explain the hazards of transactions like OTCBB listings and reverse mergers. Our plan is to distribute the materials as widely as possible, both online and off. It may not put the bad guys out of business, but at least it will make it easier for Chinese SME bosses to know which questions to ask, what kind of track record to look for or, more often,  run away from.

I’ll be sharing soon on this blog  the English version of some of this information.

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