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”.

I’m flying back from China as I write this, and bringing with me something of great value to me personally — even if I can’t claim to recognize every character. It’s the Chinese-language report prepared by my China First Capital colleagues on how a Chinese SME can avoid the quicksand and plan a successful IPO. Built on a first draft in English of mine, it’s written specifically for Chinese SME bosses. The report is called “如何选择上市的时机和地点”. 

Download Here: 如何选择上市的时机和地点 “When & Where to IPO for Chinese SME”

We prepared the report with the explicit goal to help SME bosses make more informed decisions in capital-raising and IPO. There’s been an acute lack of reliable, well-researched information in Chinese on this topic. We hope the report will improve this “information deficit”. 

For me personally, this is the most important report we’ve prepared thus far for SME bosses. As this blog has discussed at length recently,  Chinese SMEs have been victimized disproportionately by every form of IPO indignity, from US OTCBB listings, to reverse mergers, Malaysian IPOs, SPACs and other schemes promoted by the predatory bankers, lawyers and advisors that swarm around China. 

Indeed, there are few bigger risks to a successful Chinese SME than making the wrong decision and heeding the wrong advice on where and when to IPO. 

I’d welcome feedback on the report. You can email me at ceo@chinafirstcapital.com

For those who can’t read the report in Chinese, it provides a comprehensive summary of pluses and minuses for Chinese SME of listing on the US, Hong Kong and Chinese stock markets. It also discusses at length, with several case studies,  the damage done to good Chinese SME by OTCBB listings and reverse mergers in the US. The bad examples abound. 

Even if you can’t read the Chinese, I hope you’ll consider sending it on to those active in China’s capital markets, as well as to any Chinese businessmen contemplating a public offering.  Better Chinese-language information is the strongest antiseptic to kill off the bad deals and bad dealmakers in China. So, I hope all those with a genuine interest in promoting entrepreneurship in China will help spread the word.

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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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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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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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