Finding hidden value in Chinese convertibles

UG Investments plans to spearhead the opening of China''s closed end funds, replicating its experience in Taiwan.

Taiwan-based hedge fund UG Investments has launched its sixth fund - this time investing in undervalued assets in China. The UG Hidden Dragon Fund has been launched with $10 million under management sourced from the fund managers and the fund's Taiwan-based investors.

Richard Fan, principal at UG Investments, says the fund currently has a capacity of $30 million, with size being limited by the amount of QFII quota. However, he believes the fund will be able to increase in size as it acquires more QFII capacity over time.

UG Investments was among the earliest hedge funds to launch in Asia and was established in 1998 by ex-Yuanta Securities broker Eugene Wang and ex- Bankers Trust prop trader Richard Fan. The duo were seeded by a group of Asian high net-worth individuals.

UG currently manages $150 million in assets in its five funds, in addition to managing discretionary portfolios. "The Hidden Dragon fund will adopt a longer-term approach to investments compared to our flagship multi-strategy fund, which is a more trading-focused fund," says Fan.

He expects the new fund to enjoy an annualized return of around 15-20%, higher than the 15% expected for the multi-strategy fund. Fan says that approximately 65% of the new fund will be invested in Chinese bank-guaranteed convertible bonds, the underlying being domestic, consumption-driven companies that own their own stores and outlets.

Fan explains that in the current environment, with equities at six-year lows and property prices at all time highs, companies in China with rich land assets are undervalued. He believes strong GDP growth will continue to push more of China's population into the middle class, ensuring strong domestic consumption and increasing demand for property ownership.

In addition he believes the renminbi will appreciate in the near future, increasing the value of these investments. "The fund will have exposure to cheap equities, rising property prices and an undervalued currency," says Fan.

In addition, he notes that the CBs are themselves undervalued and were issued on very favourable terms with considerable protection for investors.

"The CBs we invest in are bank guaranteed, which mitigates the credit risk we take," he argues." Interest rate risk is also reduced as most have a step up coupon and even the equity risk is reduced as the CBs come with a clause which allows the conversion price to be lowered if the share price trades below that level for a certain period of time.With these terms, the CBs should be priced much higher than they are at present."

The other 35% of the new UG fund will be invested in China-listed closed end funds. "There are 54 closed end funds in China at the moment," he comments. "These have large cash holdings and are trading at a 30% discount to NAV. Our strategy is to buy into these and then force them to open up, redeeming our shares at NAV and realizing value."

He and his partner, Eugene Wang are planning to replicate the strategy they used in Taiwan, where they pioneered the opening of closed end funds. The duo have been involved in opening 27 of Taiwan's 29 closed end funds, extracting $1.8 billion for investors since 1993.

"This is the right time to start investing in closed end funds in China," Fan says. "Last year China finally put regulations in place allowing shareholders to call a meeting and defining what quorum is needed for decisions to be made. Now that these regulations are in place, we know the rules of the game."

He expects opening China's closed-end funds will be easier than his experience in Taiwan. "We expect to see less resistance from fund managers than we experienced in Taiwan," he concludes. "Taiwan was a smaller and more controlled market. In China the market is large and disparate so it is more competitive and every fund manager is driven to perform."