Chinese firms which listed in the US via reverse-merger only to become tainted by association amid fraud allegations and targeted by short-sellers are now lining up to delist. However, they face high hurdles and a long wait to re-list closer to home, restructuring experts warn.
“It was probably a mistake for most of these companies to list in New York for a start,” suggests Bob Dodds, managing director at DRP Capital, which advises Chinese companies on restructurings and mergers.
He notes that when China is flavour of the month with investors, US-listed China stocks attract interest. “But when there are China worries, the stocks go down, or they’re at risk of not attracting any interest at all and just kind of fade.”
About 100 Chinese firms have gone public in the US via backdoor listings – taking over a publicly traded but defunct listing. The process enabled them to skip the years-long wait to go public in China, and at the same time saved hundreds of thousands of dollars in costs and gave them a prestigious American ticker symbol.
But now that the segment has been marred by accusations of fraud at companies including China MediaExpress Holdings, Duoyuan Global Water and Sino-Forest and targeted by American short-sellers including Carson Block’s Muddy Waters and Andrew Left’s Citron Research. Even legitimate companies have been left to rue their decision to list in the US.
“There have been a number of frauds alleged in the States and the real companies have been thrown out with the bathwater,” one Shenzhen-based American financial adviser and investor says, preferring to remain anonymous.
“A lot of those companies aren’t really able to benefit from being public. If you’re an entrepreneur, why would you raise capital at two- or three-times earnings? It doesn’t make sense.”
Twelve US-listed Chinese firms have announced plans to go private since the start of 2010 including China Fire & Security, which is working with Bain Capital, and Chemspec International, which has an offer from Primavera Capital to buy its outstanding shares.
Even after deals are announced, a company’s US-listed shares often trade at a discount of 20% or more from the buy-out price, reflecting scepticism that the deals will close as planned.
The Shenzhen-based investor has been buying shares in firms such as China Natural Gas, China Security & Surveillance Technology and Tongjitang Chinese Medicines, looking to benefit from that arbitrage opportunity.
“These are not home-runs, but in this type of environment there’s nothing wrong with taking an intentional walk,” he says, using a baseball analogy.
It is private equity firms that are leading the charge to de-list in the US. They are keen to establish an exit strategy for any company they help to take private – which typically involves a fresh listing in Hong Kong, where Chinese firms are better understood by investors – and are more highly priced.
Maurice Hoo, co-head of the private equity practice at law firm Orrick, says over 40 US-listed Chinese firms are currently studying de-listing in the US and re-listing in Hong Kong. Interest has spiked in the last four months after US investors abandoned the segment. Bloomberg’s Chinese Reverse Mergers Index is down 54% so far this year.
But Hoo is unsure how many will be successful. “A lot of people are looking at that, but not everyone will be able to do it,” he says. “It is really not that simple.”
US capital markets base their regulatory system on disclosure, he explains, so even if a company discloses negative issues it’s up to investors to interpret them.
Hong Kong’s system is merit-based, so companies have to prove profitability of at least HK$20 million ($2.6 million) in the year preceding listing and HK$30 million combined for the two years prior to that – which may prove a challenge for smaller stocks with a spotty track record.
“The requirements in Hong Kong are actually more stringent in terms of financial history,” says Oliver Stratton, co-head of restructuring specialist Alvarez & Marsal in Asia. “That’s why they went to Nasdaq and did reverse mergers.”
The Hong Kong stock market also requires a public float of at least 25% of a company’s shares, and only recognises a handful of other domiciles such as Bermuda or the Cayman Islands.
Since Nevada corporate structures were often used for reverse mergers in the US, Chinese firms – technically American as they are incorporated in Nevada – may have to risk de-listing and then asking for a special exemption to re-list in Hong Kong – which is far from a given.
They could also move their domicile, but that could trigger tax issues, with investors considered to have sold their Nevada stock and bought into another corporate entity.
There’s also the issue that there may be more frauds yet to be exposed. The companies should know if they are genuine businesses with decent cashflow that would justify de-listing and re-listing. But private equity firms risk being caught out.
“If you see a wholesale going private, just as you saw a wholesale reverse-merger trend, you can bet some of them on the go-private side are going to fail,” says Tom Jones, also co-head of the Asian business at Alvarez & Marsal.
“The question is whether private equity firms will have a better chance of doing due diligence than the investment banks that did the reverse mergers. My feeling is yes, they’re putting their own money to work.”
Chinese entrepreneurs who took their companies to the US may also resist the idea of de-listing, even though the most pessimistic observers argue that the entire segment of Chinese small-caps listed in the US is dead.
It may appear like an admission of failure, while there will be more advisory fees to pay. Re-listing is also likely to take at least a year, experts note.
“If it’s a good company and their stock price is low, there’s a lot of things a financial adviser could help them with,” says Dodds.
But he concedes it’s a tough sell. “You’re saying, ‘The last adviser who told you to list in New York was wrong, but believe me I’m right – and you’ll have to pay me this fee.’”